Pockets of debt illiquidity show rising bank fears

NEW YORK: Pockets of the fixed income and money markets are starting to reflect concern that recent volatility will extend past August, and that growing risk aversion may again royal banks and funding markets.

One sign of worry is the increasing reluctance of banks to use their balance sheets to facilitate trades, which has hit sectors from corporate bonds to the short-term repurchase market, where there is $1.6 trillion in tripartite loans.

For example, banks have reduced activity in the intra-dealer Treasury repurchase agreement market by 63 percent since the end of June, according to Barclays Capital.

To some, this spreading risk aversion suggests that an autumn of troubling headlines could again spark a freeze like the 2008 crisis. There is no shortage of potential flash points, from Europe's debt crisis to a weak US economy.

"I think the markets are going to get much stressed," said Abdullah Karatash, head of US fixed income credit trading at Natixis in New York.

"All this uncertainty could just lead to a big leg lower in stocks and when that happens bank financial stocks are going to lead the way lower," he said. "It's gonna hurt their balance sheet and that's going to further hurt the liquidity picture."

Large money funds have been pulling back on making unsecured loans to European banks, and instead moving to secured transactions. This has left the banks scrambling for dollar-based funding and, in one rare case, led a bank to tap a liquidity line at the European Central Bank.

Three-month interbank dollar lending rates also rose again on Tuesday to their highest in over a year.

In some recent cases illiquidity in the corporate debt market has also led investors to credit default swaps for protection as selling the bonds was too costly.

Volatility, if it persists, may again threaten bank funding, which is highly vulnerable to investor confidence.

"There has been a tremendous uptick in volatility across various markets and usually it takes a lot of time for things to settle on down," said Mirko Mikelic, senior portfolio manager at Fifth Third Asset Management in Grand Rapids, Michigan. "This is probably not just an August thing."

There are some mitigating factors.

Credit lines offered by central banks might make the risks of a repeat of 2008 less likely. Banks have also much higher capital levels since the financial crisis.

That said, some traders worry things could worsen.

The corporate bond market, for example, has seen spotty liquidity, traders said.

Bank of America's credit default swaps hit records last week as investors struggle find buyers for its bonds.

With rising interbank borrowing costs, futures contracts have also been implying three-month loan rates could rise as high as 60 basis points in December.

This suggests nerves that funding pressures could increase over the new year period, when many banks reduce lending to tidy balance sheets for year-end.

"The reason the contracts peak in December is worry about year-end funding pressures," said Ira Jersey, interest rate strategist at Credit Suisse in New York.

Money market funds are increasingly nervous of European banks, and some are hesitant to lend longer than overnight.

Commercial paper loans to banks have dropped by 15 percent, or $90 billion, since the beginning of June and lending to European banks has dropped 20 percent, according to Barclays.

This has left European banks struggling to obtain the dollar funding they need to finance US exposures, and sent the cost of swapping euros to dollars to post-crisis highs.

ECONOMY, EUROPE CATALYSTS

Whether funding problems worsen is likely to depend on the economy, and events in Europe, where policymakers are increasingly struggling to contain the region's debt Reuters

"I think what's going to drive it more than anything is this macroeconomic backdrop and these extraneous shocks coming from Europe," said Karatash.

European banks are seen as more vulnerable than US banks, which have increased liquidity since the financial crisis of 2008, and reduced their reliance on short-term loans.

European banks have been raising rates on bank deposits in a bid to lure more funds from customers as large U.S funds continue to back away from term lending.

Many also continue to have high cash hoards stored on deposit at the US Federal Reserve.

Any panic over their funding, however, still risks bringing some banks under pressure.

"This could be Europe's 2008. That's probably the major concern for the market, what does that mean for the ripple effect on our capital markets and globally," said Mikelic.

A CDS index based on of 25 European financials is also reflecting elevated concerns over their credit quality.

The index traded on Tuesday at 242 basis points, just under last week's record 260 basis points and much higher than the 210 basis point peak reached at the height of the financial crisis, according to data by Markit.

Copyright Reuters, 2011

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