25 August 2008

Credit Seizing Up

By Liz Capo McCormick and Gavin Finch

Aug. 25 (Bloomberg) -- Most of the bond strategists and salesmen that Resolution Investment Management Ltd.'s Stuart Thomson talked to last August expected the credit crunch to be long over by now. Instead, money markets show there's no end in sight, and it may even worsen.

''It's like an ongoing nightmare and no one is sure when we're going to wake up,'' said Thomson, a money manager in Glasgow at Resolution, which oversees $46 billion in bonds. ''Things are going to get worse before they get better.''

In a replay of the last four months of 2007, interest-rate derivatives imply that banks are becoming more hesitant to lend on speculation credit losses will increase as the global economic slowdown deepens. Binit Patel, an economist in London at Goldman Sachs Group Inc., said in an Aug. 21 report that nations accounting for half of the world's economy face a recession.

The premium banks charge for lending short-term cash may approach the record levels set last year, based on trading in the forward markets, where financial instruments are sold for future delivery. Back then, concern about the health of the banking system led investors to shun all but the safest government debt, sparking the biggest end-of-year rally for Treasuries since 2000.

''These problems going into year-end are likely to be worse this time round because of the amount banks have to refinance in December,'' Thomson said, citing a figure of $88 billion. ''The suspicion is that banks are still hiding losses. The banking system relies on trust and at the minute there quite simply isn't any.''

Rate Spreads

Banks are charging each other a premium of 77 basis points over what traders predict the Federal Reserve's daily effective federal funds rate will average over the next three months to lend cash. The spread is up from about 24 basis points in January, and may widen to 85 basis points, or 0.85 percentage point, by mid-December, prices in the forwards market show.

Former Fed Chairman Alan Greenspan said in June that this spread, which is the difference between the three-month London interbank offered rate for dollars and the overnight indexed swap rate, should serve as a measure for telling when markets have returned to normal.

A narrowing to 25 basis points in the so-called Libor-OIS spread would be viewed as a positive, he said. Forward markets signal that won't happen until sometime after June 2010. The premium averaged 11 basis points, or 0.11 percentage point, in the 10 years prior to August 2007.

Another 2007

Increased turmoil in the money markets may again serve as a catalyst for a surprise year-end rally in Treasuries like the one in 2007.

''The trade to do in December will be to get back into the most liquid thing you can find,'' such as Treasury bills or notes, said David Keeble, head of fixed-income strategy in London at Calyon, a unit of Credit Agricole SA, France's second- largest bank by assets. ''We are having a period now of a second round of pressures on banks. It's weak economic growth which is now piling the pain onto the banks.''

A year ago, 10-year note yields fell about half a percentage point to 4 percent between September and December, even though the median estimate of 65 economists surveyed by Bloomberg was for a rise to 5 percent. Treasuries returned 3.98 percent, versus 1.92 percent for company debt and a loss of 3.82 percent in the Standard & Poor's 500 Index, according to Merrill Lynch & Co.

And just like last year, economists and strategists are again calling for an increase in yields. The median of 52 estimates in a Bloomberg survey between Aug. 1 and Aug. 8 was for 10-year Treasury yields to rise to 4 percent by the end of 2008.

Flow of Cash

The yield on the benchmark 4 percent note due in August 2018 closed at 3.87 percent last week, rising from 3.31 percent after the Fed engineered the bailout of Bear Stearns Cos. in March and inflation accelerated to the highest level in 17 years.

''The credit crunch remains the centerpiece of our bond strategy,'' said Resolution's Thomas. He said he's bullish on Treasuries maturing in five years or less.

Banks began to hoard their cash when rising defaults on subprime mortgages led two Bear Stearns hedge funds to seek bankruptcy protection on July 31, 2007, as creditors forced them to liquidate at least $4 billion of securities tied to the loans.

Then on Aug. 9, 2007, Paris-based BNP Paribas SA halted withdrawals from three investment funds because it couldn't ''fairly'' value their subprime debt holdings and the European Central Bank took the unprecedented action of offering to pump unlimited cash into the banking system. The BNP funds had about 1.6 billion euros ($2.2 billion) of assets.

'Systemic' Problems

Losses and writedowns on securities related to home loans to people with poor credit now exceed $504 billion at financial institutions. Last month Treasury Secretary Henry Paulson was forced to seek congressional authority to inject unlimited capital into Fannie Mae and Freddie Mac, which are responsible for about 42 percent of the $12 trillion U.S. home loan market, after their shares tumbled about 90 percent, wiping out some $54 billion of stock market value.

Trust among banks remains low even after the Fed cut its target rate for overnight loans to 2 percent from 5.25 percent in September and created three emergency lending programs, including the Term Auction Facility, or TAF. In total, the Fed has provided almost $1 trillion of emergency loans.

The Fed's most recent lending survey released Aug. 11 said that more banks tightened credit standards for consumers and business borrowers since April as defaults and delinquencies on home loans climbed.

Libor Validity

''The problem is much more systemic than was widely anticipated a year ago,'' said Michael Darda, chief economist for MKM Partners LLC in Greenwich, Connecticut. ''Not only bank balance sheets but home balance sheets are under pressure due to falling house prices.''

The seizure in the credit markets and rise in short-term borrowing costs this year triggered questions over the validity of Libor, a benchmark administered by the London-based British Bankers' Association and used to calculate rates on $360 trillion of financial products worldwide.

The Bank for International Settlements in Basel, Switzerland, said in March some members of the BBA may have understated their borrowing costs to avoid being seen as having difficulty raising financing.

''Libor markets aren't reflective of the entire banking system but of three or four major banks that continue to have pressure on liquidity,'' said Saumil Parikh, a money manager who helps oversee $688 billion at Pacific Investment Management Co., in Newport Beach, California. ''That spreads to the entire system because you are not really sure who you are going to end up lending to through the Libor market.''

'Not Over'

Restrictive lending makes it harder for growth to accelerate in U.S. economy, where gross domestic product may slow to 1.5 percent this year, according to the median forecast of 76 contributors in a Bloomberg survey that puts a greater weighting on most recent estimates.

Meanwhile, Europe's GDP unexpectedly fell 0.2 percent in the second quarter, while Japan's economy shrank at an annual rate of 2.4 percent in the same period.

The crisis is ''not over and I'm not exactly sure when it's going to end,'' Nobel Prize-winning economist Myron Scholes said Aug. 21 at a conference in Lindau, Germany, featuring 14 Nobel laureates in economics.

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