Bank-to-bank lending freezes; bankers ask, who is next?

Date: Tuesday, March 18, 2008
Author: Mike Dolan and Kirsten Donovan, Reuters.com

LONDON (Reuters) - Financial trading and interbank lending almost ground to a halt on Monday as banks grew fearful of dealing with each other following Friday's near collapse of U.S. investment firm Bear Stearns, prompting talk of another round of coordinated central bank aid.

As banking stock prices and the U.S. dollar plummeted, banks' access to unsecured borrowing from other banks fell to a relative trickle and dealers said the over-the-counter market had become highly discriminatory, depending on the bank name.

The seizure in money markets was reflected in a dramatic 80 basis point surge in overnight dollar London interbank offered rates, the biggest daily increase since the attacks of September 11, 2001.

"Banks and institutions are just scrambling for cash, any cash they can get their hands on," said a money market trader at a European bank.

"And it's seen as a U.S. market problem for the moment, or a dollar problem anyway," he said, noting the relatively modest increase in overnight euro and sterling Libor.

Published dealing rates were unreliable and analysts said any bank that had not already secured funding further than a week or so would struggle to raise cash at all.

"Bear's near-collapse and takeover accelerates the liquidity crunch and the money market crisis," Dresdner Kleinwort analyst Willem Sels told clients in a note.

"Banks' risk aversion and sensitivity to counterparty risk should rise even further, leading to more pressure on hedge funds. Money markets are having a brutal wake-up call."

As various pockets of the global short-term credit market froze, investors flocked into Treasury bills and cash-like investment to shelter their money from the credit turmoil.

For example, the three-month T-bill yield, seen as a "risk-free" return on U.S. assets, briefly fell below 1 percent to its lowest level in about five decades.

COMING TO TERMS

Bankers said they were struggling to assess developments since the New York Federal Reserve said on Friday it was propping up the stricken firm via Wall St bank JP Morgan, and intense concerns about the stability and solvency of financial counterparties caused dealing volumes in lending markets to seize up.

In an effort to minimize the fallout and in conjunction with the fire sale of Bear Stearns to JP Morgan, the Fed on Sunday cut its discount lending rate by a quarter percentage point to 3.25 percent and announced another series of liquidity measures.

But with concerns about whether other firms may meet a similar fate to Bear Stearns, nerves on every trade were jangled.

"It's quite illiquid this morning. If you want unsecured cash you're really going to have to pay up for it. It's really quite an intense situation," said Calyon analyst David Keeble.

Banks led the losers as stock markets lost more than 3 percent. Royal Bank of Scotland and Barclays fell more than 8 percent. HBOS slid more than 11 percent and Alliance & Leicester shed more than 7 percent.

Shares in Lehman Brothers dropped as much as 46 percent before ending the day down 19 percent in U.S. trading.

"There's turmoil in all markets after Bear Stearns," said BNP Paribas strategist Edmund Shing. "Everyone's asking: Who's next? Is there a Bear Stearns in Europe? Could investment banks start to fail?"

The problem was said to be particularly acute in sterling markets, with the gap between indicative three-month interbank borrowing rates and the Bank of England loans more than 70 basis points -- the highest for the year.

Some analysts said major players on the interbank market had been doing as little as 700 million pounds a day of business over the past week, a fraction of the several billions that would have been executed a year ago, and far less on Monday.

"Counterparty risk is back in play, every trade is being scrutinized ahead of time," one interest rate trader said. "

The stress in the market forced the UK central bank to make an emergency offer of five billion pounds of three-day funds.

"This action is being taken in response to conditions in the short-term money markets this morning," the bank said in a statement. "Along with other central banks, the Bank of England is closely monitoring market conditions."

For policy-makers and traders looking for encouraging signs in the credit market, at least in the United States, the yield spread on two-year interest rate swaps over Treasuries, a gauge of risk aversion, shrank to its tightest since mid-February.

U.S. federal funds, or overnight loans on surplus bank reserves, fell to 2.00 percent in late trading, more than a full percentage point below their session high of 3.5 percent.

PROBLEMS EVERYWHERE

Three-month euro interbank rates were also some 65 basis points above ECB rates, compared with around 40 basis points at the start of the month. The spread reached a peak of around 90 at the end of last year.

Dollar spreads were also wider than on Friday but heavy discounting of further Fed rate cuts have meant the spread has actually narrowed this month to around 65 versus 80 basis points at the start of March.

The European Central Bank declined to comment, even though speculation of coordinated central bank statements, liquidity injections and even synchronized rate cuts circulated around markets.

A German Finance Ministry spokesman said no extraordinary meetings of the Group of Seven economic powers was planned. "We're watching developments very closely in the United States."

But International Monetary Fund chief Dominique Strauss-Kahn said the global financial markets crisis was worsening and risk of contagion was increasing.

With the dollar sliding to record lows, traders said currency options markets were seizing up too, another reflection of the state of panic and fear that appears to be dominating all financial markets.

Implied volatilities on FX options, a measure of expected volatility in the underlying asset price and investors' demand to protect themselves against these moves, soared on Monday.

As the dollar sank to 13-year lows against the yen further below 100 yen, one-week dollar/yen implied "vols" jumped to 25 percent, a level not seen since 1999.

"This is a market where you should be on your guard. Shorting options is quite a difficult position to manage," said the senior FX trader in Tokyo.

(Reporting by Jamie McGeever and Sitaraman Shankar in London and Richard Leong in New York)