Armageddon fears ease, but lending needs to begin again - FT

Credit markets have been swift to pass judgment and people there believe that emergency government actions around the world have staved off financial armageddon. However, even though the cost of protecting US and European bank debt against default has fallen by more than half or even two-thirds for many names from their recent extraordinary highs, interbank lending rates have been slower to respond. The Libors have shrunk back from recent highs across currencies and maturities, while forward rates also have declined, -suggesting a brighter outlook. However, most rates - with the notable exception of overnight dollars - remain extremely elevated. For example three-month dollar Libor is down 20.25 basis points over the past two days, but that still leaves it at the highly elevated 4.55 per cent, which compares to the much improved 2.14 per cent for overnight dollar Libor. It is still more than 400bp higher than the yield on three-month Treasuries. The disparity suggests that it may take some time before a big change for the good in sentiment about the banking industry has a real, practical impact on liquidity. It also suggests that -liquidity could be a much more complex and subtle problem than is summed up in the short-hand description of "a lack of trust between banks". For individual bank liquidity managers, things are a lot better than they were at the end of last week when money markets and the whole fabric of banking was close to collapse. However, the wave of relief that greeted measures to inject public money into bank capital and to guarantee some debt issues is giving way to a nervous desire to see how those policies will work. Some analysts are very optimistic. Laurence Mutkin at Morgan Stanley says that widening spreads on bank credit default swaps (CDS) have been pushing up the difference between Libor and market expectations of central bank interest rates - as measured by overnight interest swaps (OIS). This Libor-OIS spread - in effect the base cost of money outside of central banks - could now decline dramatically, hot on the heels of tumbling CDS spreads, once interest rate expectations stabilise (see chart). "[The] sharp improvement in bank CDS demonstrates the rather binary nature of confidence in the financial system and in financing markets," Mr Mutkin says. "As long as governments don't slip up with their support programmes - and we don't see why they should - they can succeed in transforming the financing markets with surprising speed." However, others are less sure. Lou Crandall, economist at Wrightson Icap, thinks it is unclear whether there will be a significant impact on unsecured funding markets, which are what Libors price. "There are almost no natural lenders in the [unsecured] term money markets apart from money market mutual funds," says Mr Crandall. "Counterparty risk may have been the reason for the initial pullback . . . but investors' worries about their own liquidity exposure could make them slow to [return] even though the bank safety net has been strengthened." The impact of the collapse of Lehman Brothers on liquidity has been two-fold. The first was in creating more pain for the value of all financial assets, many of which are used as collateral. This had made it more difficult to borrow at all in private repo markets and means that even when collateral can still be deployed into central bank lending operations less money can be borrowed against it. This has left banks in danger of "running out of collateral" for secured funding and so more reliant on unsecured funding at the very moment that the fear surrounding further bank collapses led money market funds to abandon lending into that market. The collateral issue is being tackled by the European Central Bank with yesterday's measures to loosen and broaden what banks can use in its operations. Meanwhile, government guarantees on bank borrowing are hugely important in opening up funding options in the 18-month to three-year maturity range, according to liquidity managers and analysts. But one of the trickiest and most subtle problems remains. Banks bidding for central bank liquidity have to do so first thing in the morning, yet it is only at the end of each day when they must balance their books that their funding position becomes apparent. There is an argument that the hoarding of liquidity among banks has always been less to do with a broad lack of trust that others will still be standing tomorrow and more to do with the fact no bank could be sure it could borrow from anyone at the close of the day if it found itself short. In that scenario, a bank's only option would be to use central bank emergency facilities. The experience of Barclays in summer 2007 when its share price was hit hard by persistent talk it had done just that shows why no bank wants to be stuck with that option. Furthermore, according to Matt King of Citigroup, now catastrophe has been averted, banks still need to shrink their balance sheets and the lack of visibility on funding means a lack of capital for market-making that will likely keep credit markets illiquid - and hence vulnerable both to forced selling and to the weight of supply. "Make no mistake: we're delighted to see that the patient has regained consciousness, but it's still likely to be a long while before they're up and walking again," he says.