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October 09, 2008

Credit Markets Remain Frozen Economy

With all of the extraordinary steps that have been taken, you might expect the credit market would be easing. But you'd be wrong. It's getting worse. Bloomberg:

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.

Attempts by policy makers to restore confidence to money markets are being stymied by almost daily crises among financial institutions. Iceland's government took over the nation's biggest lender today to keep the country's banking system working. American International Group Inc., the insurer taken over by the U.S. government, may need $37.8 billion of extra funds, the Federal Reserve Bank of New York said yesterday.

"To see little or no reaction in the fixings is very disappointing and reinforces the fact that Libor is broken and the transmission mechanism from central banks isn't working," said Barry Moran, a currency trader in Dublin 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."

The London interbank offered rate, or Libor, for three-month loans rose to 4.75 percent today, the highest level since Dec. 28. The Libor-OIS spread, a measure of cash scarcity, widened to a record. The overnight rate fell to 5.09 percent, still 359 basis points more than the Fed's 1.5 percent target rate. [...]

"I don't see a wave of liquidity coming into the market," said Alessandro Tentori, an interest-rate strategist in London at BNP Paribas SA. "People are still holding on to their cash because there's still a great deal of uncertainty out there." [...]

The Libor-OIS spread, the difference between the three-month dollar Libor and the overnight indexed swap rate, climbed 23 basis points to an all-time high of 348 basis points. The average was 8 basis points in the 12 months to July 31, 2007, before the credit squeeze began. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, widened 5 basis points to 410 basis points, the most since Bloomberg records began.

"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."

It certainly seems that the problem in the credit markets is just what Nouriel Roubini has been saying all along: nobody knows which apples are the good apples and which are the bad apples. That is, nobody knows which banks or companies are next to fail. So nobody wants to lend to anybody. The underlying problem is a lack of transparency. That, and the fact that it's impossible to give meaningful valuations to many of the trillions of dollars in derivatives that are out there (since there's no market where they're traded) so it's impossible to separate fact from fiction on many companies' balance sheets. The bottom line: nobody knows who to trust. As Roubini has been saying, there needs to be a program of triage, where the good apples are saved and the bad apples are shut down. Only then will people begin to trust counterparties enough to loan them money. My guess is that the crisis will have to get worse, though, before governments have the nerve to undertake something so radical.

Posted by Jonathan at October 9, 2008 09:46 AM  del.icio.us digg NewsVine Reddit YahooMyWeb