Tuesday, July 29, 2008

Talk of quick fix recedes as Libor gap fails to close

(FT) Libor, the measure of inter-bank interest rates that is a key barometer of the health of the credit markets, continues to signal problems a year into the credit crunch and raises doubts about whether the financials' share prices are close to a bottom.

The daily setting of floating interest rates is used to calculate prices on loans, mortgages and the vast derivatives markets. There is a growing realisation that the all-clear signal for the banking sector will not sound until the difference between Libor and the overnight rates set by central banks narrows from its current elevated levels.

Jim Paulsen, chief investment strategist at Wells Capital Management, says: "The persistence of fear one year later remains very troubling.

"The equity market is still fearful and that is fanned by what investors see in the present level of Libor, credit default swaps and interest rate swap spreads."

Swaps, which measure the expected difference between overnight rates set by central banks and three-month Libor, remain wide. In the US, the so-called Overnight Index Swap (OIS) is about 73 basis points, while in the UK it is 67bp and for the eurozone 62bp. Prior to last summer these swaps were trading at about 15bp.

At least the situation appears no longer to be deteriorating. OIS rates have pulled back from their peaks of about 100bp touched last December and in the weeks leading up to the collapse of Bear Stearns in March.

George Goncalves, strategist at Morgan Stanley, says: "We are not seeing widening pressure in Libor, which is the only silver lining at the moment".

He expects that OIS swaps should narrow to about 35bp but adds that forward starting swaps for 2009 indicate the swaps will ease to only about 50bp next year.

He says: "The Fed is on hold and we are now getting a decent read on how much it will cost banks to fund their balance sheets".

At the heart of the elevation in Libor are concerns over the health of bank balance sheets, where weakness can spill over to the broader economy because it limits the availability of credit to companies and consumers.

Dominic Konstam, head of interest rate strategy at Credit Suisse, says: "Libor has been a barometer of the need for banks to raise capital. The main problem with Libor is the capital strains facing banks."

When Libor started rising last August, some analysts compared money market rates to oil for the financial markets engine. While the warning light was flashing red, there was a debate whether this engine needed a quick top-up of fresh oil or whether it was signalling a full seizure was imminent.

Bank writedowns were expected to last one or two quarters. However, the writedowns keep coming a year later and many institutions are still seeking capital and restricting their lending.

Mr Goncalves says: "The first shock was specifically about writedowns at the banks. Now it is about ascertaining what their balance sheets are worth in an environment of declining credit availability."

Such worries about the health of banks and their need to raise further capital will keep money markets on the defensive, with institutions reluctant to lend to each other. That restriction in lending is filtering through to the broader economy and poses a threat to future growth.

Mr Konstam says: "We now face something worse than elevated Libor and the deleveraging of the financial system, and that is an outright recession".

Some of the problems in Libor stemmed from banks in Europe who required dollar funding to finance their holdings of dollar assets. As the funding strains grew, so institutions sought to borrow in the euro and sterling money markets. This pushed money market rates higher in the major currencies, a situation that still persists.

This month, the European Central Bank auctioned $25bn to banks and attracted heavy demand. Meanwhile, US banks continue to borrow for a period of 28 days from the Federal Reserve's Term Auction Facilityand a total of $150bn is outstanding.

The Federal Reserve established the TAF in December to arrest the upward pressure on Libor ahead of year-end, when financing demand usually climbs. While that programme helped ease some strain, money markets endured fresh upheaval this year, culminating in the collapse of Bear Stearns in mid-March. Just before Bear was sold to JPMorgan, the Fed announced the creation of the Primary Dealers Credit Facility (PDCF) for at least six months. Ben Bernanke, Fed chairman, has said that that PDCF is likely to be extended into 2009.

Traders have argued that the terms of the TAF should be extended to three months. That would help ease three-month Libor but such a move would involve the Fed more deeply in propping up the money market.

Bankers note that central banks in Europe offer funds for terms of three and six months or, in the UK, for even longer. But so far, the Fed has resisted extending its TAF programme.

Another issue for Libor was raised this summer. Some analysts said the problems with Libor reflected the way the measure was being calculated. The daily fixings are set in London by the British Bankers' Association. Of the 16 banks who supply quotes for dollar Libor, only three are US based.

That prompted the BBA to announce in June that it would consider two alternative daily fixings for dollar Libor.Anxiety over the mechanics of Libor has eased as a daily fixing set in New York by banks contributing quotes to Wrightson Icap, the interdealer broker, has shown little difference.

Mr Konstam says: "Initially there was some confusion that Libor itself was the problem, with talk of the rate being manipulated and not representative of the true cost of borrowing".

Quick fixes are now no longer part of the discussion.

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