Just In Case You Think the Credit Crunch is Behind Us

Just in case you thought the credit crunch is over the ECB continues to pump liquidity into the capital markets in Europe. Also the Fed has recently seen increased activity at the discount window. From the WSJ two days ago:

With European banks stockpiling cash and wary of lending to each other for periods longer than a week, the European Central Bank pumped €75 billion, or about $104 billion, in three-month credit into money markets yesterday in another effort to bring dealings back to normal.

The extra longer-term funding, the second such maneuver in nearly three weeks, was in addition to the ECB's routine injections of three-month funds and contrasted with the shorter-term funds the ECB has also been providing to the market.

The operation was exactly what European commercial banks say they have been seeking in discussions with the ECB over the past week or so. Like most central banks, the ECB is in constant contact with commercial banks.

Still, three-month euro interbank offered interest rates continue hovering around 4.75%, their highest levels since May 2001 and well above the ECB's target lending rate for overnight funds of 4%. Usually, the gap is smaller.

The tensions in European money markets reflect a confluence of forces. One is concern among European banks that other banks still have undisclosed exposure to the U.S. subprime-mortgage market. Another is the eagerness of European banks to hoard cash for various reasons.

ECB policy makers have been laboring to help unnerved money markets function normally. ECB President Jean-Claude Trichet last Thursday said the bank would make additional three-month money available, just as it did on Aug. 23 when it injected an extra €40 billion. But the ECB didn't indicate an amount until it acted yesterday.

The ECB's action comes at a crucial time. Corporate IOUs called commercial paper have been central to the credit turmoil. Some $139 billion in euro commercial paper started maturing earlier this week and will continue to do so in coming days, so banks have been scrambling for cash and pushing up rates in the interbank-lending market. Banks told the ECB that three-month funds would enable them to put the money to use for a longer period of time, according to a person familiar with the situation.

Commercial-paper traders believe it will be another four to six weeks before investors reappear at full strength. But there already are some signs of a modest recovery. Yesterday, $24.85 billion of euro commercial paper was issued, more than offsetting the $21 billion that matured. There also are indications that money-market investors have forsaken some overnight deposits for higher-yielding one-month and three-month paper.

Adding to the crunch, banks have been stockpiling cash to cover financial backstops required by affiliates known as conduits that haven't been able to renew maturing commercial paper. These conduits typically issue short-term commercial paper to buy higher-yielding, longer-maturing assets such as securities backed by U.S. mortgages. Another factor sapping cash are moves by banks to step in and pay off large chunks of the maturing commercial paper issued by their affiliates.

Many believe the ECB's ability to resolve the fundamental distrust infecting European markets is limited. The perception, right or not, is that the finances of European banks are less sound than those of their U.S. counterparts and that the unregulated European vehicles affiliated with banks that have undisclosed exposure to U.S. subprime mortgages are less well-managed than those in the U.S.

Many of the complex securities at the heart of the current crisis aren't traded on exchanges. That makes them difficult to value and -- policy makers say -- is helping spur a broader-based risk aversion.