One Year Later, Still Crunch Time
It was little over a year ago (August 9 2007) when short-term credit markets froze and the ECB, Fed and BoJ started pumping billions of dollars into their systems to ease the liquidity crisis associated with the subprime crisis. In the following days, the three central banks continued their injections of liquidity into the money markets. Various mortgage originators, inside and outside the U.S. started drawing billions from their credit lines and filing for bankruptcy. On August 17 2007, in an unscheduled meeting, the Fed cut the discount rate half a percentage point (after leaving rates unchanged in the FOMC meeting that took place ten days earlier). From then onward the central banks of the developed world kept injecting funds to ease the liquidity crisis and started accepting a wider range of collateral.
One year later, in the U.S. the lack of improvement in the money markets is still taking center stage and the Fed – on top of having cut the Fed Funds by 325bps – continues to expand its liquidity facilities and lengthen the maturity profile of the Term Auction Facility without significant impact on credit creation.
3 month Libor (orange) – Overnight Indexed Swap (white) (spread below)
Supply and demand of credit are both suffering a severe downturn, as highlighted by the Fed’s Senior Loan Officer Survey for Q3 2008. The contraction in bank lending seen in the recent weeks is unprecedented and, while U.S. financial institutions will be in need for refinancing of billions of dollars in maturing debt in the next few months, they also have to cope with mounting credit-related losses and rising funding costs. This could force banks to raise lending rates, thus exacerbating the squeeze felt by U.S. businesses and individuals and aggravating the downturn in economic activity.
Investor demand for Auction-Rate Securities (ARS) froze as of February on waning confidence in the credit strength of insurers backing the debt, and on reluctance by dealers to submit bids and free up liquidity, despite the higher yields on the debt. By now, the involved dealer banks have been forced by NY state attorney Andrew Cuomo to buy back more than $40bn in illiquid paper from investors in addition to pay fines in the millions of dollars.
The next stage might very well be a contraction in real U.S. household spending as a result of the erosion in credit quality and of the tightening of the credit conditions – this would mark the first consumer recession since the beginning of the 1990s.
The European money market faces similar problems as the U.S. Despite the ECB’s generous term lending framework, Euro denominated interbank spreads refuse to recede significantly. On a similar vein, the latest Bank Lending Survey of the Euro Area underscores the current stress situation for banks and points to a tighter credit environment for consumers and corporations alike. Given the EU corporations’ higher reliance on bank funding, the asymmetric exposure to credit conditions among EMU countries is bound to fuel economic divergences going forward and make the ECB’s common monetary policy all the harder.
Credit market weakness is also affecting emerging markets. The global credit crisis has exacerbated home grown liquidity squeezes in countries like South Korea. Large oil revenues and improving domestic liquidity have cushioned Russian banks and corporates, but their reliance on short-term rollover financing may pose risks, particularly if inflows ease along with commodity prices. Even petrodollar-sheltered GCC countries are facing higher financing costs. Major project financing demands, slow deposit growth, (triggered in part by very negative real interest rates) at a time when local and global U.S. dollar funding is scarce and central banks are restricting lending to dampen money and price growth have led interbank rates to rise sharply – while global banks are flocking to the GCC.
Kuwait Interbank 3 Months Index
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