Bank Funding Crunch Deepens as Swap Rates Soar: Credit Markets

Monday, May 10, 2010
By Paul Martin

By Shannon D. Harrington and Abigail Moses

May 10 (Bloomberg) — Europe’s government debt crisis is starting to infect the bank funding system, driving borrowing costs higher from Asia to the U.S. and threatening to slow the global economic recovery.

The interest rate financial companies charge each other for three-month loans in dollars rose to the highest since August, while traders are paying record amounts to hedge against losses in European bank bonds. Yields on corporate debt rose last week by the most relative to government securities since Lehman Brothers Holdings Inc.’s bankruptcy in September 2008, according to Bank of America Merrill Lynch indexes.

European Union policy makers unveiled an unprecedented loan package today worth almost $1 trillion. A statement from the region’s finance ministers highlighted “a risk of contagion which we needed to address.” The European Central Bank will intervene in secondary markets for securities, EU Economic and Monetary Affairs Commissioner Olli Rehn said in Brussels after a 14-hour emergency meeting.

“Whether the markets completely unravel depends on whether politicians can stabilize the peripheral government market,” said James Gledhill, who helps manage about 58 billion pounds ($85 billion) as head of fixed income at Henderson Global Investors Ltd. in London. “The tail risk is the stress on banks which stops them from lending to corporates and feeds through to become a real economy problem.”

Bond Sales Plummet

Global corporate bond issuance plummeted last week, with $9.4 billion sold, the least this year, following $30.1 billion in the previous five-day period and $47.9 billion in the week ended April 23, according to data compiled by Bloomberg. JPMorgan Chase & Co. said in a May 7 report it’s ending a recommendation that investors own a greater percentage of junk bonds than contained in benchmark indexes.

The sovereign debt crisis may end up costing governments more than $1 trillion, according to credit investment firm Aladdin Capital Holdings LLC in Stamford, Connecticut.

“Look for the de-risking that is underway to continue,” the New York-based bank’s fixed-income strategists including Srini Ramaswamy wrote. “Funding pressures have increased for European banks and could worsen over the near term, but are unlikely to deteriorate to the extent seen in 2008 that led to forced deleveraging.”

The three-month London interbank offered rate in dollars, the rate banks pay for loans, jumped 5.5 basis points to 0.428 percent on May 7. It climbed 8.2 basis points on the week, the biggest increase since October 2008.


The spread between three-month dollar Libor and the overnight indexed swap rate, a barometer of the reluctance of banks to lend, jumped to 18.1 basis points on May 7, three times the 6 basis-point spread on March 15 and the highest since August.

“At the moment, it feels worse than 2008,” said Geraud Charpin, a fund manager at BlueBay Asset Management in London. “There is no buyer of risk in the market.”

The five-year euro interest rate swap spread, the difference between the rate to exchange fixed- for floating- interest rates and yields on government debt, widened 18.65 basis points to 54.13 last week, the biggest gap since March 2009. Investors concerned that Greece’s budget turmoil is spreading to other nations have piled into German bunds, considered the safest among European government securities.

‘Liquidity Drying Up’

Swap rates are typically higher than government yields because the floating payments are based on rates, such as the euro interbank offered rate, or Euribor, that contain credit risk. Swap rates serve as benchmarks for investors in debt including mortgage-backed and auto-loan bonds.

“There is a concern the market may be ceasing to function, with government bond liquidity drying up completely as everyone looks to sell,” said Mark Austen, managing director at the Association for Financial Markets in Europe. “We need quick and decisive action from the authorities.”

The rate at which Royal Bank of Scotland Group Plc told the British Bankers Association it could borrow for three months jumped 14 basis points last week to 0.5 percentage point. Barclays reported rates that increased 11 basis points to 0.45, while Societe Generale SA, France’s second-largest bank by market value, said its climbed 8 basis points to 0.45 percentage point.

Short-Term Loans

Rates being charged for short-term loans are more than 90 percent below the record levels in 2008, as banks are in better shape to weather a market seizure than when the U.S. subprime mortgage market collapsed. The Libor-OIS spread reached a record 364 basis points in October 2008.

“The price action is probably as bad as anything we saw in September ‘08, although it feels like the dealers are better positioned now than they were then,’’ said James Palmisciano, chief investment officer of the $1.7 billion Gracie Credit Fund in New York. ‘‘So it feels like customers are poorly positioned now, as opposed to both dealers and the customers being poorly positioned.’’

The extra yield investors demand to own corporate debt instead of government securities soared 28 basis points to 177 basis points, or 1.77 percentage point, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. The index, which peaked at 511 basis points in March 2009, dropped to as low as 142 on April 21.

Spreads on European bank bonds widened 48 basis points last week to 238 as of May 7, the highest since September, according to Bank of America Merrill Lynch’s EMU Financial Corporate index. The index’s 1 percent loss this month follows returns of 0.49 percent in April and 1.12 percent in March.

‘Interrelated, Large’

Concern that European leaders will need to bail out more countries than just Greece flared from New York to Sydney last week, prompting investors to shun all but gold, dollars, yen and the safest government securities. Led by Italy’s $126 billion, Greece, Spain, Portugal, Ireland and Italy have a total of $215 billion of debt coming due in the next three months, according to JPMorgan.

‘‘When we’re told something’s contained, it almost never is,” said Brian Yelvington, head of fixed-income strategy at broker-dealer Knight Libertas LLC in Greenwich, Connecticut. “There were a lot of people who didn’t realize how fully interrelated and large this is.”

Under today’s loan package, euro-area governments pledged 440 billion euros in loans or guarantees, with 60 billion euros more in loans from the EU’s budget. The International Monetary Fund may provide a further 250 billion euros, Spanish Economy Minister Elena Salgado said.

The Federal Reserve said it will restart its emergency currency-swap tool by providing as many dollars as needed to central banks in Europe, the U.K. and Switzerland.

Credit Swaps

Investors seeking to protect themselves from losses on bonds or speculate on creditworthiness by buying credit-default swaps drove up benchmark indexes in Europe and the U.S. last week by the most since December 2008, CMA DataVision prices show.

Bond risk tumbled today in Asia, with the cost of protecting Asia-Pacific bonds from default dropping the most in a year. The Markit iTraxx Asia index fell 22 basis points to 115, Deutsche Bank AG prices show. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt.

A swaps index tied to 25 European banks and insurers including Spain’s Banco Santander SA and Portugal’s Banco Espirito Santo SA rose the most on record last week. The Markit iTraxx Financial Index of credit-default swaps surged as much as 105 basis points last week to 223 on May 7, the highest on record, before ending the week at 177 basis points, according to JPMorgan prices.

Espirito Santo

Credit-default swaps on Lisbon-based Banco Espirito Santo surged 207.5 basis points last week to 613.5, the highest end- of-day level on record, CMA prices show. That would cost 613,500 euros a year to protect 10 million euros of the bank’s debt from default for five years.

Swaps on Banco Santander, the biggest Spanish bank, rose 102 basis points last week to 247, also a record, CMA prices show. In Australia, contracts on Macquarie Bank Ltd. increased 61.5 to 174, the highest since July 2009, according to CMA. Contracts on New York-based Goldman Sachs Group Inc., the most profitable Wall Street bank in history, rose 46 basis points on the week to 213, reaching the highest in a year.

Highest Rates

Top-ranked companies are willing to pay investors some of the highest rates since at least August to borrow in the market for commercial paper, according to offer yields compiled by Bloomberg.

The average yield on 30-day commercial paper climbed to 0.31 percent on May 7, the highest since Aug. 26, up from 0.24 percent a week ago and almost double the record low reached in February. Rates for overnight loans jumped to 0.25 percent, the highest since July, from 0.2 percent 10 days earlier.

“Lenders in both the commercial paper and deposit markets have begun moving away from certain counterparties,” Joseph Abate, a money-market strategist at Barclays Plc in New York, wrote in a May 6 note to clients. “At the same time, the willingness to lend to all counterparties for terms greater than three months has declined.”

Brazilian corporate bond sales, off to the best start to a year, are being derailed by the highest borrowing costs in three months. Yields on corporate dollar bonds surged 54 basis points last week to 6.56 percent, according to JPMorgan.

Odebrecht SA, a Salvador, Brazil-based construction and engineering company, suspended its planned $200 million sale May 7, the company said in an e-mail. Banco Cruzeiro do Sul SA, a Sao Paulo-based bank, postponed a 10-year dollar bond offering until market conditions improve, said investor relations superintendent Fausto Vaz Guimaraes Neto.

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