Lending Among Banks Freezes

Banks abruptly stopped lending to each other or charged exorbitantly high rates Tuesday, threatening to spread the troubles of American International Group Inc. and Lehman Brothers Holdings Inc. to a broad range of financial institutions and the global economy. The breakdown came despite efforts by central bankers to keep money flowing. Central banks in the U.S., Europe and Japan pumped tens of billions of dollars each into the banking system. The Federal Reserve, while declining to lower its benchmark interest rate at a regular meeting Tuesday, said it will "act as needed" to combat ills including tight credit and the still-declining housing market. In one stark sign of waning confidence, the overnight London interbank offered rate, or Libor, a benchmark reflecting the rates at which banks lend to one another, more than doubled, in its sharpest spike on record. Longer-term Libor rates also rose sharply. If sustained, that move will push up payments on billions of dollars in mortgages and corporate loans that are linked to Libor. The tensions reverberated around the world on a day of sharp gyrations in stock and bond markets. The Dow Jones Industrial Average, which was down more than 100 points during the day, ended up 141.51, or 1.3%, to 11059.02 as investors welcomed news that the Fed was weighing a plan to support AIG. Individual financial shares were all over the map, as investors tried to sort out who will survive the market turmoil. Commercial banks, seen as more stable because they can tap consumer deposits for funding, were up sharply. Bank of America Corp. rose 11.3% and Wachovia Corp. was up 9%. The investment bank Morgan Stanley was down 10.8%, prompting it to rush out its better-than-expected financial results a day early. Prices of government bonds, a traditional safe-haven investment, rose sharply. It was "a nausea-inducing rollercoaster ride," wrote Benjamin Cheng, a strategist at UBS. From Russia to Switzerland, officials were at times forced to suspend trading as stock prices plunged. Both major Russian stock exchanges halted trading for an hour late in the day, the first time they had both done so since Russia's 1998 financial crisis. As rumors spread about their funding, some banks took the rare step of denying problems. Switzerland's UBS AG, refuting an analyst report on its potential exposure to Lehman-related losses and countering a 17% drop in its stock price, said its total loss exposure to Lehman wouldn't exceed a manageable $300 million. Belgian-Dutch bank Fortis, which saw its shares fall more than 10%, denied in a statement that it was seeking a capital injection. In the U.K., HBOS PLC, a big mortgage lender that depends heavily on market funding, said it had a strong capital position as its share price fell 22%. Demand Exceeding Supply The European Central Bank provided €70 billion ($99 billion) in one-day loans, more than double its Monday injection of €30 billion. The Bank of England offered £20 billion ($35.66 billion) in extra two-day loans, atop Monday's £5 billion in three-day loans. In recent days, demand for such central-bank funding has far exceeded supply. Before the Fed's midafternoon rate decision, the Federal Reserve Bank of New York injected $50 billion into the banking system, and added an additional $20 billion later Tuesday. Normally banks can rely on each other for cash to meet daily needs. The interest rates are usually low relative to other market rates, reflecting confidence that fellow financial institutions will pay each other back. But that confidence broke down in August 2007, and has never been fully restored. The central banks' efforts Tuesday were just the latest in a long string of emergency maneuvers since the crunch began. Those efforts have failed to get money circulating normally, putting central bankers in the uncomfortable position of propping up banks for periods longer than they had ever intended. Tuesday's turmoil reflects the impact a failure of AIG could have on banks and financial markets. The U.S. insurer is a major player in the $62 trillion credit-default-swap market, where banks and others buy and sell insurance against defaults on corporate bonds. AIG has sold insurance on hundreds of billions of dollars in debt to European banks alone. That insurance could prove worthless in the event of an AIG bankruptcy filing, precipitating billions of dollars in fresh losses for banks. Because the insurance is sold in the form of private contracts, not even policy makers know exactly how much there is or who will end up taking the losses. "These things are invisible to everybody," says Howard Simons, a bond strategist at Bianco Research in Chicago. Even more, the downfall of the once rock-solid insurer has underscored to financial institutions that no one is free of risk. The worries about AIG are making the outcome markets fear more likely. For one, they have caused the cost of default insurance to rise sharply. That forces sellers of insurance, which include AIG, to put up added cash as collateral to guarantee they'll be able to pay in the event of a default. The added demand for cash exacerbates the money-market strains. The Libor Soars The depth of the money-market problems became clear at lunchtime in London, when the British Bankers' Association published Tuesday's Libor borrowing costs. Every day, 16 banks report what it would cost them to borrow at certain maturities and currencies. Overnight dollar Libor soared to 6.4375% from 3.10625%, the largest jump on record. Three-month dollar Libor rose to 2.876% from 2.816%. Big global banks such as Bank of America, Credit Suisse Group, UBS, Royal Bank of Scotland Group PLC and others reported overnight borrowing costs of 6% or higher in dollars, compared with 3% just a day earlier. In another sign of policy makers' concerns about banks' access to cash, the Bank of England is expected this week to propose a new permanent emergency-financing facility for troubled banks. The program will likely be designed to allow the central bank to help banks secretly, making short-term loans against collateral that would include hard-to-sell assets such as mortgage securities, say traders and analysts. Private Borrowing Pool The banking industry is also working to create a separate, private borrowing pool, though details are still being ironed out. Under the guidance of the New York Fed, 10 of the world's biggest banks have committed to chip in $7 billion each to the fund, dubbed the Primary Dealer Liquidity Facility. Any of the member banks can borrow up to one-third of the total fund. The structure seems intended largely as a confidence-building measure to assure jittery investors that major banks won't run out of cash. Banks won't actually fund the facility unless one of its 10 members needs to borrow from it. On Monday, representatives of the banks and law firm Davis Polk & Wardwell, which the New York Fed hired to provide advice, met to discuss issues such as what kind of assets banks can pledge as collateral when they borrow from the facility. The banks are also drawing up a list of specific circumstances in which banks can tap the fund, such as if they have lost access to the commercial-paper market, where banks and other companies issue short-term IOUs. More meetings are expected to take place in coming days. One of the outstanding goals is to enlist at least a few more banks to join the facility, which was originally intended to have about $100 billion coming from 15 different lenders.