By Michael Mackenzie, David Oakley and Gillian Tett
November 9 2007
SourceIn recent days, the faceless bankers who work in the Treasury departments of some of the world's largest banks have started to get uneasy as it has become clear that the summer credit crisis is far from over.
The angst stems from expectations among investors and banking analysts that more red ink from financials is inevitable. As banks face having to write down further securities, derivatives and credit structures that reference the deteriorating US mortgage market, many fear a protracted period of stress for the financial system.
"What's now clear is that the mess is here to stay, and that it's likely to get worse for homeowners and the banks long before it gets better," said William O'Donnell, strategist at UBS.
"The worst is yet to come, and we are heading into year-end when there is a lack of liquidity," said TJ Marta, fixed-income strategist at RBC Capital Markets.
The latest evidence that things are getting worse was a fresh contraction in the commercial paper market, an important source of funding for financial institutions. Also, there are signs that interbank borrowing rates remain at unusually elevated levels, three months after the crisis began and after three months of efforts by central banks to calm things.
Yesterday, the asset-backed commercial paper market experienced its largest decline in two months. In recent years, banks have set up off-balance sheet vehicles that use mortgages and other assets to issue ABCP.
Investors have shunned such paper in the past 13 weeks, causing a 29 per cent contraction in the market since its peak in early August. The ABCP market accelerated its decline last week, shrinking $29.5bn to a seasonally adjusted $845.2bn, according to Federal Reserve data. The overall commercial paper market declined $15.6bn and reversed a rebound that began at the start of October. The European ABCP market has also contracted.
Issuers of ABCP such as structured investment vehicles - unable to tap investor capital in the commercial paper markets - have been forced to tap bank credit lines. This has forced financial institutions to batten down the hatches as their balance sheets suffer. In turn, the plunge in many banks' share prices has exacerbated the burden on balance sheets. The S&P financials sector is down more than 20 per cent from its peak in February and the cost of insuring financial debt against default is at a five-year high. Amid the stress in commercial paper and among financial institutions, key money market rates and derivatives have not returned to normal levels in spite of two cuts in the Fed's key interest rate totalling 75 basis points.
Yesterday, the three-month dollar London interbank offered rate - an important borrowing benchmark for financial groups - set at 4.887 per cent, 38.7bp above the funds rate. Normally, Libor should be about the level of the funds rate.
This week, the two-year dollar interest rate swap spread also showed signs of stress. This spread is a measure of flight-to-quality concerns between Treasury and money market collateral and seen as a proxy for the credit risk of banks. It traded above 80bp over the two-year note yield this week, its widest level since 2000.
Another closely watched index is the level of dollar Libor versus euribor as measured in the foreign exchange forwards market - a series that shows the cost of swapping euros into dollars at a future date. During August this surged, because European banks were frantically attempting to raise dollars and being shunned by US banks. And while this indicator also dropped last month, in recent days it has edged up again.
In Europe, three-month Euro Libor is trading more than 50bp above the European Central Bank's base rate amid strains in the European ABCP market.
According to bankers, the European ABCP market has shrunk in the past two weeks to about $170bn from $180bn. The market was valued at $300bn in outstanding contracts in July, just before the credit crisis blew up.
Looking ahead, tough times beckon, say traders, and they worry that the usual heightened demand for funds at the end of the year will exacerbate high tensions in the money market.
One swaps trader said: "Two weeks ago the world seemed rosy, but the mood is much grimmer now, almost as bad as in August. I think it is a confidence thing. With money markets rates remaining high and rumours flying around of more trouble ahead for the banks, everyone is very nervous."
Yesterday, the yield on the two-year Treasury note fell to 3.45 per cent, down from 3.65 per cent on Monday and its lowest level in more than two years. As bond traders monitor the deepening gloom in the mortgage market they believe the Fed will have no choice but to keep cutting interest rates.
Ben Bernanke the Fed chairman, told Congress: "Financial market volatility and strains have persisted." However, faced with a plunging dollar, Fed policymakers have stressed their concerns about inflation and sought to downplay the bond market's expectation of further rate cuts.
"The bond market is no longer crying wolf," says Mr Marta.
"The rocket scientists who built models made the same mistakes as Long-Term Capital Management in 1998; they didn't factor in a convergence of correlation when things headed south."
Copyright The Financial Times Limited 2007