naked capitalism

Even though the Fannie and Freddie near crisis, which produced a few days of panic in the credit markets, now seems to have abated, money market investors are still on edge. The Financial Times warns that various risk measures remain at elevated levels:

Libor, the measure of inter-bank interest rates that is a key barometer of the health of the credit markets, continues to signal problems a year into the credit crunch and raises doubts about whether the financials’ share prices are close to a bottom….There is a growing realisation that the all-clear signal for the banking sector will not sound until the difference between Libor and the overnight rates set by central banks narrows from its current elevated levels.

“The persistence of fear one year later remains very troubling,” says Jim Paulsen, chief investment strategist at Wells Capital Management. “The equity market is still fearful and that is fanned by what investors see in the present level of Libor, credit default swaps and interest rate swap spreads.”

Swaps, which measure the expected difference between overnight rates set by central banks and three-month Libor, remain wide. In the US, the so-called Overnight Index Swap (OIS) is about 73 basis points, while in the UK it is 67bp and 62bp for the eurozone. Prior to the credit crunch last summer these swaps were trading around 15bp.

At least the situation appears no longer to be deteriorating. OIS rates have pulled back from their peaks of around 100bp touched last December and during the weeks leading up to the collapse of Bear Stearns in March.

“We are not seeing widening pressure in Libor, which is the only silver lining at the moment,” says George Goncalves, strategist at Morgan Stanley. Over time, he expects that OIS swaps should narrow to around 35bp but adds that forward starting swaps for 2009 currently indicate the swaps will only ease to around 50bp next year….

At the heart of the elevation in Libor are concerns over the health of bank balance sheets, where weakness can spill over into the broader economy because it limits the availability of credit to companies and consumers.

“Libor has been a barometer of the need for banks to raise capital,” notes Dominic Konstam, head of interest rate strategy at Credit Suisse. “The main problem with Libor is the capital strains facing banks.”….

“The first shock was specifically about writedowns at the banks,” says Mr Goncalves. “Now it is about ascertaining what their balance sheets are worth in an environment of declining credit availability.”

Such worries about the health of banks and their need to raise further capital will keep money markets on the defensive, with institutions reluctant to lend to each other. That restriction in lending is now filtering through to the broader economy and poses a threat to future growth.

“We now face something worse than elevated Libor and the deleveraging of the financial system, and that is an outright recession,” warns Mr Konstam.

Some of the problems seen in Libor stemmed from banks in Europe who required dollar funding in order to finance their holdings of dollar assets. As the funding strains grew, so institutions sought to borrow in the euro and sterling money markets. This pushed money market rates higher in the major currencies, a situation that still persists.

Earlier this month, the European Central Bank auctioned $25bn to banks and attracted heavy demand.

Meanwhile, US banks continue to borrow for a period of 28 days from the Federal Reserve’s TAF program, and a total of $150bn is outstanding….

Quick fixes are now no longer part of the discussion.