Overnight dollar Libor has soared to its highest level in 7 years today. More significant yet, a look at the Libor-OIS spread - which strips out the underlying central bank interest rate risk from consideration and the move is all the more significant.
With such stress in interbank lending, it’s little wonder the Fed is drastically ramping up its open market operations. Funding increased $129bn last week to stand at $528bn (up $219bn on the month). That doesn’t even count yesterday’s doubling of the TAF to $300bn.
Even so, the Fed’s actions are limited. At these large sizes, banks’ short term liabilities are still not necessarily adequately covered.
To take a European example that could easily be transposed to the US, the failure of Hypo Real in Germany yesterday was because Depfa, which Hypo took over late last year, could not meet its short-term financing needs, in spite of enlarged central banking facilities throughout Europe. A Caz note this morning attributed Depfa’s problems to €54bn in unsecured money market funding:
Even if DEPFA had eligible collateral to pledge at the ECB, the size of the portfolio relative to the two main liquidity windows (MRO €180bn, LTRO €50bn) dictates it probably could not have refinanced there anyway.
The ECB’s most recent LTRO auction, on the 24 Sep, was three times oversubscribed.
Unable to secure overnight funding from peers or central banks, financial institutions are turning to the commercial paper markets. The yield on 30 day CP for financials, at 3.14 per cent, compares pretty well with Libor. But it’s nonetheless a measure of desperation that banks find themselves dependent on CP markets: volatility in which is more or less what spread the financial crisis so far and wide in the first instance, one year ago. Northern Rock collapsed because it could not roll its CP.
This chart is from the credit strategists at Bank of America:
As the chart shows, longer-term CP issuance is collapsing, and banks - and corporates - are only able to access financing with the very shortest of maturities. As Jeffrey Rosenberg - whose chart this is - says:
Eventually, unless the situation improves, commercial paper maturities will snowball into overnights, leaving a significant portion of short term financing for the banking sector to be decided on a day-by-day basis.
Day-to-day is not a good time horizon for knowing the health of the world’s banks.
What makes the CP market so dangerous a thing to be dependent on right now is the ailing health of its major players - the ultra conservative money market funds.
“Prime” money market funds are those which invest in corporate and financial commercial paper. As the above chart shows, they have seen more than $400bn in redemptions over the past two weeks. The downward trend continues in spite of a government backstop on those funds.
If investors continue to withdraw, then the buyer universe for financial CP will continue to shrink. With the Tarp shelved, money market funds will be more discriminate in buying CP.
The consequence should be more collapses. And not just among banks either. Prime funds are pulling drastically back from buying CP issued by regular corporates too. What with the end of quarter funding spike approaching, it’s not a pretty time to need money.
The situation can only hold for so long. Eventually the effects of the tremendous stress in the money market will work its way onto Main Street, and from there, presumably, onto the stock exchanges.
