Short-term Debt Markets Appear to be Stabilizing

The Wall Street Journal

Short-Term Funding Strengthens

Banks Venture Back Into Debt Some Saw As Too Dangerous


Short-term funding markets are showing some signs of stability as the second quarter gets underway, suggesting the Federal Reserve’s liquidity-providing efforts continue to help right these markets that were all but shuttered earlier this year.

The mad dash for only the safest debt has subsided and banks have ventured back into loans longer than overnight. But continued robust commercial-bank borrowing from the Fed and still high interbank lending rates suggest that strains remain in the broader banking system.

“We’re not seeing a resurfacing of flare-ups” in short-term funding markets, said George Goncalves, chief Treasury strategist at Morgan Stanley in New York. However, “so long as there’s uncertainty in the financial system, overall liquidity will stay at a premium,” he said.

Fed Chairman Ben Bernanke told a conference Tuesday that “although short-term markets remain strained, they have improved somewhat since March,” thanks to the Fed’s actions and banks’ capital-raising efforts.
In the repo market, where investors borrow and lend securities in short-term loans, rates have relaxed and passed through quarter-end with little hoopla. For Treasurys, agencies and mortgage-backed securities, overnight rates in the repo market are in the range of 0.08 percentage point to 0.20 percentage point above the 2% federal fund target rate, levels that Mr. Goncalves called “normal business operations.” In the overnight Treasury repo market last year, rates plunged and even turned negative.

Activity in the overnight repo market has slowed recently given the added supply — the Treasury has increased the size of its recent auctions and this year added the one-year Treasury to the mix — and as banks’ desire for only the safest and the shortest loans has relaxed. As of June 27, overnight repo borrowing outstanding stood at a net of $3.7 trillion, down from $4.2 trillion this spring.

Term repo, where banks make loans to each other for periods longer than overnight, has also improved from its near-frozen state. As of June 27, term repo borrowing outstanding was at $3.7 trillion, up from $2.5 trillion in the first week of April, according to Mr. Goncalves.

Despite these encouraging developments in repo, signs abound that bank-funding issues are still serious. “Interbank funding market stress is continuing,” said Priya Misra, interest-rate strategist at Lehman Brothers in New York.

Borrowing at the Fed’s discount window — the Fed’s primary source of emergency funding — remains historically high, as are interbank lending rates. The gap between those rates and market expectations for the fed funds rate has widened, standing at 0.73 percentage point Tuesday.

Treasurys remain well-bid, with the 10-year note adding 13/32 point, or $4.0625 for every $1,000 invested, to yield 3.880% Tuesday. The two-year note rose 1/32 to 100 26/32 to yield 2.452%. Bond yields fall when prices rise.

Fannie, Freddie Revive

Mortgage bonds guaranteed by Fannie Mae and Freddie Mac rebounded Tuesday, erasing the dramatic losses seen in the previous trading session when investors worried the two finance giants faced capital shortfalls.

Market participants credited the snapback in mortgage bonds — as well as the debt the two companies issue to finance their business — to bargain hunters who were reassured by soothing words from Fannie and Freddie’s regulators.

“The concerns are still there, it’s just that investors saw an opportunity level here for them to enter the market,” said John Sim, a mortgage strategist with J.P. Morgan Chase.

Risk premiums, or spreads, on these agency mortgage-backed securities were 0.11 percentage points tighter to the corresponding Treasurys, a strong rebound from the 0.10 percentage point they had stretched against Treasurys Monday.

Clearinghouse as Bank

A central clearinghouse being planned for the credit-default swap market may be set up as a bank that is regulated by the Federal Reserve Bank of New York, a letter from the Fed to Sen. Charles Schumer indicated.

Major credit-derivative dealers have been working with Chicago-based Clearing Corp. to set up a clearinghouse that will guarantee their trades and help reduce counterparty risk, or the risk that individual firms can’t meet their trading obligations. Credit-default swaps are private contracts that protect their holders against bond and loan defaults; they trade directly between banks, money managers and others.

In a letter Monday, Fed officials said “it is our understanding that the current plan is for the central counterparty for credit derivatives to apply to the New York State Banking Department for a charter for an uninsured bank and to apply to the Federal Reserve Board to be a member” of the New York Fed.

If that occurs, the New York Fed will regulate the central CDS counterparty. The letter, signed by Fed chairman Ben Bernanke and New York Fed president Timothy Geithner, was in response to questions posed last month by Sen. Schumer.