Over the last two weeks, we have said that central bank liquidity measures had become counterproductive. Throwing more liqiudity at banks made it more viable for them to depend on monetary authorities and not rely on private sources for funding, and in turn extend credit to them.
One contributing factor not mentioned in many of today’s media reports is that today is the settlement day for Lehman credit default swaps. The auctions are expected to produce losses to protection writers or 80 to 85 cents on every dollar of guarantee provided. Banks are believed to be hanging on to cash both to pay for their own settlement and out of fear that their counterparties may take irreperable damage in the Lehman settlement process. There may be some relief if the financial community passes this test, but with another big settlement, WaMu, later this month, banks are still likely to remain on high alert.
The cost of borrowing in dollars for three months in London soared to the highest level this year as coordinated interest-rate reductions worldwide failed to revive lending among banks for any longer than a day.
The London interbank offered rate, or Libor, for three-month loans rose 23 basis points to 4.75 percent today, the British Bankers’ Association said. That’s the highest level since Dec. 28. The Libor-OIS spread, a measure of cash scarcity, widened to a record 350 basis points. The overnight rate fell 29 basis points to 5.09 percent. That’s still 359 basis points more than the Federal Reserve’s target rate of 1.5 percent.
“To see little or no reaction in the fixings is very disappointing and reinforces the fact that Libor is broken and that the transmission mechanism from central banks isn’t working,” said Barry Moran, a Dublin-based currency trader at Bank of Ireland, the country’s second-biggest bank. “Things are still very stressed and we don’t know what’s going to fix it in the short term.”
The European Central Bank today offered banks as much cash as they need for six days at its benchmark rate of 3.75 percent, bringing forward new measures to soothe money markets. It also loaned banks a record $100 billion in overnight dollar funds, allotting most of the cash at 5 percent, down from 9.5 percent yesterday…
The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened to a record 412 basis points.
“Libor spreads are still wide, which suggest offshore banks are not willing to take more risks lending to other banks,” said Cezar Bayonito, a liquidity trader at Allied Banking Corp. in the Philippines. “Interest-rate cuts will be of little help in the near term because the issue is trust, not rates.”…
Overnight rates on dealer-placed commercial paper rose 56 basis points to 3.5 percent yesterday, while investors seeking a haven for their money pushed the yield on three-month Treasury bills down 15 basis points to 0.6 percent. Bill yields rose 3 basis points today, to 0.65 percent.
The Financial Times mentioned a particularly troubling development, that banks are not even lending to each other on a repo. In a repo, a bank sells liquid, high credit quality securities under an agreement to repurchase, and gets cash in the interim. The fact that they will not lend in return for collateral is mind-boggling.
From the Financial Times:
Stress across money markets intensified yesterday in spite of the unprecedented round of co-ordinated interest rate cuts by central banks aimed at helping banks gain access to funds.
In recent days, central banks have pumped vast amounts of liquidity into the short-term lending markets, only for banks to hoard the cash and not lend to other banks. As well as the rate cuts, the US Treasury tried to alleviate lending problems in government bond markets by making more of its bonds available for collateral.
“The concerted central bank rate cuts should provide some relief in [Thursday’s] fixings, but the funding will remain very tight, with negative effects on the economy mounting,” said TJ Marta, strategist at RBC Capital Markets.
The breakdown in trust between lenders and borrowers since the bankruptcy of Lehman Brothers in mid-September has paralysed short-term funding markets. Institutional investors are unwilling to risk lending unsecured funds to banks, or even buy commercial paper beyond one day issues by highly rated companies.
The reluctance to lend between banks and other investors has also created chaos in the government repurchase or repo market, another important source of short-term funds for banks. In a repo transaction, sellers of debt securities promise to buy them back later for an agreed price.
Investors have stopped lending cash to banks even in return for collateral such as US Treasuries. That has broken the chain of lending between numerous banks to such an extent that borrowed securities have not been returned. These so-called “repo fails” prompted the US Treasury yesterday to re-open various Treasury issues and sell more debt yesterday.