Tuesday, September 30, 2008

Fed, central banks keeping the heat on frozen money markets

From MarketWatch, online at:

http://www.marketwatch.com/News/Story/fed-central-banks-keeping-heat/story.aspx?guid=%7BB9FDED4B%2D0F55%2D4115%2D9DE7%2DDA9F376CF823%7D

FED MOVES TO THAW MONEY MARKETS


By William L. Watts

1:06 PM ET Sep 29, 2008


WASHINGTON (MarketWatch) -- The Federal Reserve and other major central banks took
unprecedented steps Monday to pour hundreds of billions of dollars in additional
liquidity into money markets left paralyzed by fears of further bank failures in the
United States and Europe.

The Fed said it was boosting the size of its dollar-swap arrangements to $620
billion, up from $290 billion previously. The agreement, with nine central banks,
allows authorities to provide short-term dollar loans to commercial banks in an
effort to ease funding woes that have resulted from reluctance by commercial banks to
lend short-term funds to each other through the interbank market.

The Fed also increased the size of its liquidity auctions and announced two forward
auctions to provide funding over the year-end period.

"These steps are undertaken to mitigate pressures evident in the term funding
markets in the United States and abroad," the Fed said in a statement.

"By committing to provide a very large quantity of term funding, the Fed actions
should reassure financial market participants that financing will be available
against good collateral, lessening concerns about funding and rollover risk," the
U.S. central bank said.

Included in the Fed's swap lines are the Bank of Canada, the Bank of England, the
Bank of Japan, the National Bank of Denmark, the European Central Bank, the Bank of
Norway, the Reserve Bank of Australia, the Bank of Sweden and the Swiss National
Bank.

The biggest move doubles the amount of dollars available to the ECB, to $240 billion.

The Fed noted that dollar borrowing rates have been higher abroad than in the United
States. The bigger swap lines "should help to improve the distribution of dollar
liquidity around the globe," the Fed statement said.

Against a backdrop of turmoil in the markets, key short-term borrowing rates rose,
while spreads that measure tensions in money markets widened significantly. A wider
spread signals increased reluctance by banks to lend to each other.

U.S. Treasurys rallied as frazzled investors sought out the safety of
government-backed bonds. See Bond Report.

Aiming to stabilize Libor

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Tony Crescenzi, chief bond-market strategist at Miller Tabak & Co., said
Monday's move was aimed primarily at easing strains in the European banking system,
where dollar demand has far outstripped supply.

The move should, he said, help bring down the London interbank offered rate -- a key
short-term borrowing benchmark, known as Libor.

Three-month Libor rose to 3.88% on Monday. The spread between Libor and the federal
funds rate, which stands at 2%, remains near a 21-year high.

Crescenzi noted the implied yield on eurodollar contracts, which are essentially
bets on Libor, had fallen 12 basis points since the Fed announcement.

Europe was troubled earlier

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Earlier, the British government's nationalization of mortgage bank Bradford &
Bingley, a rescue by three governments of troubled Belgian-Dutch bank Fortis and a
consortium-led bailout of German property lender Hypo Real Estate trumped any return
of confidence in the interbank lending market stemming from agreement between the
Bush administration and Congress on a $700 billion package designed to stabilize the
financial sector, analysts said.

Across the Atlantic, banking giant Wachovia Corp. succumbed to the global credit
crunch. Regulators announced the firm's banking operations were being acquired by
Citigroup . See full story.

Also Monday, the ECB stepped up efforts to boost liquidity in the financial system,
announcing it would provide five-week loans to commercial banks in a series of
special auctions. The ECB said there was "no pre-set amount" of euros it would lend
through the auctions, and signaled it was ready to take further actions to boost
liquidity in the euro-zone banking system.

"The ECB will continue to steer liquidity toward balanced conditions in a way which
is consistent with the objective to keep very short-term rates close to the minimum
bid rate," the central bank said in a statement.

The Bank of Japan and the Reserve Bank of Australia also took steps to pump up
liquidity, and central banks around the world have poured billions of dollars into
the financial system through short-term loans in an effort to ease tight money-market
conditions in recent weeks.

The Bank of England on Friday responded to pressure from banks to provide additional
liquidity through three-month loans.

The interbank lending market plays a key role in the financial system, allowing
banks to tap short-term loans to fund ongoing operations. If the system fails to
operate, banks can have trouble meeting short-term obligations, potentially leading
to failed banks and frozen credit markets.

Fears 'run' deep

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But banks, already loaded down with their own troubled assets, are worried that they
could find counterparties insolvent. As a result, they've been afraid to lend to each
other since the collapse of Lehman Brothers earlier this month.

"Market participants are reluctant to engage in transactions with each other because
of heightened counterparty risk and fear that they could be the next in line to
experience a 'bank run' and therefore need all the liquidity they can get
themselves," wrote economists at Danske Bank in Copenhagen.

Such fears left Bradford & Bingley and Fortis struggling for funding. Their
subsequent collapse then contributed to further tensions in the money market.

Amid the money-market tensions, central banks have been "forced to get more and more
active in providing liquidity to the market because the market isn't doing it
internally," said Don Smith, an economist at brokerage firm ICAP.

"It's a continued escalation of the degree of support the central banks are
providing in terms of liquidity for the money markets, and I don't think there's very
much expectation the direction is going to reverse," he said. "There's no sense of
any fundamental improvement in conditions at all."

The Danske economists said the U.S. bailout plan goes to the core of the financial
sector's problems by removing uncertainty over future write-downs of mortgage assets,
but they acknowledged that the plan has so far done little to soothe tensions in
short-term debt markets.

'Frayed nerves'

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"The strains in money markets have reached unprecedented levels and the risk is that
investors and market participants have lost faith that the medicine will work," they
said, in a research note. "The current crisis has evolved into a confidence crisis
which could become self-fulfilling."

But Crescenzi noted that past financial crises left key gauges of money-market
tensions elevated for some time.

Both the so-called TED spread, which is the difference between the yield on
three-month Treasury bills and market interest rates, and the spread between the
Libor rate and fed funds peaked two months after the 1987 stock market crash and the
1998 credit crisis, he said, in a research note.

"It is human nature for frayed nerves to take time to heal after a shock -- healing
of any kind is more a process than an event," he said.


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