Stress Returns to Interbank Lending (It Isn’t Over Till the Fat Lady Sings Edition)

Just when market participants were patting themselves on the back, focusing on indicators that suggested the credit crunch was easing, even making forecasts that it would be behind us before year end, troubles creep back on little cat feet.

The proximate cause for Fed intervention wasn’t the subprime crisis or rise in agency spreads, but a seize-up in the money markets as banks exhibited a decided distaste for lending to each other in August and September. That led to (among other things) emergency rate cuts and Paulson launching his stillborn “save the SIVs” initiative. That worked only till November, when the difference between Libor and risk-free rates again rose, leading the Fed to launch the Term Auction Facility in December. Then trouble emerged on a new front, as agency spreads rose to attention-getting levels in late January. This appeared to be a vote of no confidence by the markets in various plans to use Fannie and Freddie as major actors in the rescue of underwater American homeowners. That resurgence of the debt crisis culminated in the sale of Bear Stearns, which many hoped was a watershed event and signaled that the worst was over.

We didn’t think so, and we appear to have company. Banks are still hoarding cash, which means the Fed’s heroic and ever-larger efforts have still not resolved the initial problem, namely, high interbank spreads. Its persistence suggests it may not be amenable to Fed action.

Update 2:30 PM Paul Krugman is not happy:

All of this involves fear of defaults by banks — despite what look from here (central New Jersey) like utterly clear signals from the Fed that bank debts will be socialized if necessary. I’m puzzled, and worried.

From the Financial Times:

Money markets in the US and Europe are signalling renewed fears about the financial strength of banks, with key confidence barometers almost returning to the levels that preceded the collapse of Bear Stearns.

The concerns are being highlighted by the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. This spread, known as the overnight index swap rate, has been rising in the US and remains elevated in Europe, indicating that banks are reluctant to lend to each other.

“Libor is still dysfunctional and, for whatever reason, banks still appear unwilling to lend funds,” said Dominic Konstam, head of interest rate strategy at Credit Suisse.

The difference between the overnight central bank rates and three-month Libor was typically about 12 basis points before global credit turmoil grew worse last summer.

In the US on Wednesday, that spread rose rose 2bp to 77.5bp. The difference had climbed above 80bp on concerns about Bear, then fell back to 60bp in mid-March after the investment bank was sold to JPMorgan Chase.

In the UK, the swap rate gained 2.45bp to 95.45bp on Wednesday. In Europe, the swap rate was up 1.29bp at 74.68bp. It had been 67bp after the Bear sale.

Investors also sought the safety of government debt on Wednesday, pushing the yield on the two-year Treasury down 12bp to 1.75 per cent.

Tensions are rising in the money markets in spite of the injection of huge amounts of liquidity into the banking system by central banks. Traders say market conditions suggest the Bear rescue has not completely alleviated worries about counterparty risks. Until confidence is restored, the availability of credit to investors and companies will be restricted, potentially hurting the broader economy.

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  1. Richard Kline

    95.45 in the City of London . . . it ain’t confidence that they’re short of.

    The last time London fell to a foreign power was 1213 (if you don’t count 1688). Well, boys, 800 would be a nice round number, but you might consider calling the Germans now and asking for terms ’cause the alternative may well be a ‘storm and a sack.’

  2. William Kidder

    The adage ‘it takes one to know one’ comes to mind. The employees of a bank knows how sick it is (whether the outside world knows about the condition or not). Therefore, it is logical to assume other banks are in horrible shape too. As the saying goes on the repo desk, “Hell, we wouldn’t even lend to ourselves!”

  3. Lune

    At what dollar amount does the problem become too large for the Fed to intervene? The Fed has already spent several hundred billion dollars. How much more does it have?

    I ask this because the Fed so far has proven itself unable to spend its money wisely (and withhold it when necessary), choosing instead to shoot from the hip every month or so and damn the consequences.

    I no longer have confidence that the Fed will act intelligently; rather my only hope is that they soon will be unable to act at all. At that point, the market might actually be allowed to function, and we might start to get a grip on this mess.

  4. Yves Smith


    There isn’t a simple answer. It depends how desperate the Fed gets. It seems unwilling to perceive that most of what it has done is either ineffective or counterproductive.

    Per this post on a WSJ story that looked like Fed PR, “dont’ worry, we have all the firepower we need,” the Fed looks to have $400 billion plus left on its balance sheet. It could always issue liabilities to enable it to take on more assets, but that’s a highly inflationary, third world kind of move that John Dizard (who claims to have connections at the Fed) says they regard as not viable. The option they seemed to favor was having the Treasury issue more debt (see option 1 for the mechanism) but it isn’t obvious that the increase in debt issuance would lead to a dollar for dollar increase in Fed capacity.

    That’s a long winded way of saying that how far the Fed goes depends on whether they exercise any restraint. Since they haven’t seemed inclined to so far, I don’t see any reason to anticipate they will, absent Congress getting some nerve (and we’ve seen perilous little of that) and reining the Fed in for effectively using taxpayer money.

  5. Anonymous

    Richard Kline – could you clarify your rather cryptic comment – do you think something big is about to blow up in London?

  6. Richard Kline

    To Anon of 4:03, with a swap rate that high, it would appear that many have no capital left to lend in London, having lost it. If so, they need a major bailout/clean-up, with would take the ECB, and lead to less autonomy for sterling. That’s strictly a hypothetical, I have no inside info; I do think this is a probable outcome of the bubble’s bursting in the UK, however.

  7. Richard Kline

    I tend to agree that most of what the Fed has done has been counterproductive and ineffective—but not irrational per se, or even panic-stupid in so many words. The market demanded cuts in September; the Fed did as it was told. Liquidity seized up terribly in November; the Fed threw the vault open, and sent bales of bills in barrows to all qualified, against cruddy collateral. The monolines stank like carrion in January, and in consequence the muni market short circuited and it looked like the GSEs were going to get massacred; the Fed put rates in a panic dive to presumably provide oxygen to gasping bankers. Some MBS spec funds and then BSC got cannibalized by the financial equivalent of flesh-eating zombies; the Fed says it will back any sizeable bank-like outfit as much as needed against the most pitifully crappy instruments known to man (’cause that’s all they have left). Oh, and we have every reason to believe that the Fed and its crony ibanks have repeatedly gamed the equities market via futures dealings at points when the stock markets looked about to turn turtle.

    At the same time, there were reports in the media (for what that’s worth) after the BSC debacle that the Fed called the Treasury to the effect that: a) the Fed did not wish or intend to go to zero on its reserves (or presumably get close enough that the markets would read it that way), and b) that the Fed was highly unhappy about lending against smashed insect collateralized junk like some of the ibanks and others were pushing at them. I suspect that the impetus for the Fed to accept such crap came from the Treasury to begin with, but that’s just sniffing the wind on this: Paulson seems to be the policy ‘decider,’ not anyone at the Fed. Thus, the idea being floated of the Treasury vomiting forth more debt to provide firepower (regardless of that _that_ will do to the $, ” . . . Our currency but [their] problem.”).

    To me, Problem No. 1 is that the Fed has been completely _reactive_ in all of these moves, never proactive. The Fed has certain tools, and a shortlist of emergency expedients to apply. Those supposed wiseheads haven’t exactly panicked but simply gone on down their checklists—without a plan or any appreciation that this crisis isn’t like ‘the last crisis,’ or indeed like any crisis in their lifetimes.

    It is no real surprise that policymakers who are used to impacting their environment are impeded by conginitve dissonance from accepting that it is their environment which has changed, and so addressing the changed conditions. This is the scary thing to me, that public financial authorities will simply keep on pressing their known buttons even as those switches are not connected to the present context. Which is: a) the financial system is collectively insolvent and needs wholesale nationalization(s), b) all asset classes are priced at severely inflated levels and must come down for the financial system to restablize and function, and c) massive distortions in international trade and investment following from a severely overvalued dollar have led to global malinvestment as different national macroeconomies have all been ‘dys-optimized’ to the resultant distortions.

    Who would want to deal with all _that_?—so the ‘stupid monkeys’ keep pushing the same old buttons in hopes that Big Daddy in Money-Heaven will smile and give ’em a cookie again. . . . Not gonna happen.

  8. Anonymous

    The fundamental issue is the FED can’t save all the banks from their losses and to this point the banks are unwilling to fess up to their losses.
    The banks are insolvent and running on borrowed time. They will try every trick in the book to put off their losses until tomorrow and act like tomorrow will never come.
    The issues associated with CDO’s are just starting and will continue for the next couple of years as the recession worsens.
    Home Price deflation.
    More Home foreclosure.
    More jobs lost.
    More Credit Card default losses.
    Less Consumer spending.
    More Job losses.
    Credit tightening on Auto loans.
    More Car loan defaults.
    More Job losses.
    and around and round we go.
    In order to re-inflate the economy the FED would have to inject into the economy 30% of the amount associated with the deflation in home prices and ease lending standards back to where they were. I wonder how many trillion dollars that is? That is not going to happen.
    I sold GE 2 months ago after I saw the words “GE Capital Finance” in a headline. Enough said.

  9. Anonymous

    Most excellent, Richard Kline.

    The component most lacking in this drama is clarity. I don’t want to put my pittance into a wall street or city snare trap.

    The gov has interpreted, and acted, as if the truth of widespread financial insolvency is horrific, and the markets are inferring the same. With the loose cannon Paulson treasury on the make like a wall street bank in heat, everyone is scared s***tless. I think it possible that the whole social security privatization thing has been subterfuge to provide liquidity from SS withholdings for the sub-prime mess. Feels like an AG/Paulson solution.

    I think I believe the cloak and dagger stuff is extremely counterproductive. Since the banks are insolvent, a mechanism needs to be considered where they are forced to open up the books, on both sides of the Atlantic.

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