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BOHICA, Pt. II: A VERY Scary Story

Comment: BOHICA is a military slang acronym for “Bend Over, Here It Comes Again!” A very disturbing story regarding the euro zone crisis was featured in The Wall Street Journal. It looks like the short-term lending to a lot of European banks is drying up…this is the kiss of death to financial institutions in today’s economy.  A huge source of financing for the kind of investing banks do involves the “commercial paper” market of short-term corporate debt. That gets constantly rolled-over (say, once a month or so), and once short-term lending to banks dries up, those banks can be utterly screwed.  As the article points out, it was a dry up of short-term lending that greatly contributed to the 2008 financial crisis.

It was drying up short term funding that also helped implode Rhineland Funding and Rhinebridge Funding, the German state-owned bank subsidiaries that operated in the US by borrowing short term from US pensions and municipalities and investing that money in subprime mortgage-backed securities.

The article also notes that a reduced appetite of banks and other financial institutions to engage in short term lending with each other has a cascading effect of increasing interest rates on corporate and residential loans.  So this is just a really bad sign all around AND it’s happening in the wake of the massive euro zone bailout package.  Looks like another mega crisis is coming.

“European Bank Lenders? Coalition of Unwilling” by Mark Gongloff, David Enrich And Sara Schaefer Munoz; The Wall Street Journal; 5/26/2010.

Lenders to the major European banks are growing increasingly cautious, demanding higher rates for shorter periods, adding further stress to an already fragile financial system.

Worries about sovereign debt have caused banks and other investors to pare risk. At the same time, new restrictions on money-market funds, which are big lenders to the banks, are forcing them to pull back on their lending.

This funding squeeze has already contributed to the recent sharp declines in stock, commodity and corporate bond prices around the world. Unchecked, it threatens a repeat of the sort of contagion that gripped credit markets in 2008. [Italics are mine–D.E.]

To avoid such an outcome, the Fed may consider reducing the interest rate it charges on U.S. dollar loans it extends to the European Central Bank. The ECB in turn could ease terms on its loans to European banks.

The London Interbank Offered Rate, which tracks the amount banks charge each other to borrow, rose on Tuesday to 0.53625, a 10-month high. The Libor increase is a key sign of banks’ wariness.

Lending rates in the commercial-paper market, where banks and other companies get short-term funding, followed suit. European 30-day commercial-paper rates for top-tier borrowers rose on Tuesday to 0.48%, the highest since last November, according to Tim Backshall, chief strategist at Credit Derivatives Research, up from about 0.3% at the beginning of April.

Spain’s Banco Bilbao Vizcaya Argentaria, or BBVA, has been unable to renew roughly $1 billion of short-term funding in the U.S. commercial-paper market since the beginning of the month, according to people familiar with the matter. The bank still has substantial European-based funding and deposits and about $9 billion in U.S. commercial paper. [Italics are mine–D.E.]
With investors increasingly finicky about credit risk, the range of interest rates European banks are paying for three-month commercial paper is three to four times wider than usual, according to Amitabh Arora, head of U.S. rates strategy at Citigroup Inc.

Ordinarily, the rates paid by issuers of commercial paper vary by 0.15 to 0.2 percentage point. This week, he said, the variation is more like 0.6 to 0.7 point.

Investors are also “unwilling” to lend for more than one month without being compensated more than usual, Citi’s Mr. Arora said. Libor rates are 0.35% for one month, but 0.54% for three months and 0.76% for six months.

During the past few weeks, several U.S. banks and money managers said they have reduced their lending to European borrowers.

“Obviously with conditions in the euro-zone as they are, people will be responsive,” said David Glocke, manager of $150 billion in taxable money-market fund assets for Vanguard Group. “We’ve taken a second and third look at our exposures over there and adjusted our portfolio where appropriate.”

U.S. money-market fund managers, which combined have some $3 trillion in assets, aren’t necessarily selling European debt. But given their importance in the market for short-term corporate lending, only modest changes in buying behavior can lead to market upheavals. [Italics are mine–D.E.]

Money-market fund managers try to buy relatively safe assets and hold them for a short time. A money-market panic in 2008 contributed to the broader squeeze in corporate credit. . . .

In an effort to prevent another such crisis, the Securities and Exchange Commission is requiring money funds to hold more-liquid and higher-quality assets, effective Friday.

The new rules will shorten the maximum weighted average maturity of a fund’s portfolio to 60 days from 90 days. Funds also will have to maintain a minimum of 10% of assets in securities that mature in one day and 30% in securities that mature in one week.

That means funds will have less appetite for longer-term commercial paper, pushing up the rates banks must pay to borrow at longer maturities.

This development comes at a particularly bad time for banks, with regulators pushing them to borrow at longer rates, to reduce their reliance on short-term financing sources and avoid blow-ups.

Borrowing costs are still well below their levels at the worst of the 2008 crisis. But short-term funding pressures were a key component of that crisis and can feed on themselves if unchecked. The situation has parallels to 2008, when the collapse of Lehman Brothers caused markets to freeze around the world.

A major contraction of bank funding could have far-reaching consequences. [Italics are mine–D.E.] . . . .


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