One year on, money markets still in intensive care

International money markets remain damaged, fragile and strained after a full year of credit losses and writedowns, and the time they will take to return to normality is now being measured in years not months.

Access to liquidity for financial institutions is still limited and expensive, particularly for periods longer than a few months, and distrust of counterparties means those that do get their hands on cash are as reluctant as ever to lend it out.

All this will keep the crisis rumbling on, perhaps for several years.

"We can still see the effects of this out to five years," said Ciaran O'Hagan, senior strategist at Societe Generale in Paris, echoing the International Monetary Fund's view that financial markets won't return to health until the US housing market recovers.

Reinforcing this view, this week, the Federal Reserve, European Central Bank and Swiss National Bank all took additional steps to pump more liquidity into financial markets.

Mr O'Hagan said signs of this stress lasting years can be viewed in spreads between forward rate agreements (FRAs) and overnight interest rate swaps (OIS).

That gap, measuring the difference in cost between accessing secured dollar, euro and sterling funds compared with unsecured interbank funds, is seen narrowing to around 40 basis points in two years from around 65 currently - still way off historic levels around 15 basis points, Mr O'Hagan said.

While financial sector losses and writedowns are generally shrinking, banks' balance sheets remain under considerable stress: Institutions are nowhere near the end of the road in terms of rebuilding their battered capital bases via raising equity or asset sales.

Central banks provide open-ended aid for many institutions via liquidity-providing schemes whose acronyms are now common market jargon: TAF, TSLF, SLS. The crisis, rooted in complex financial structures built round the US housing market, has spread from US mortgages to virtually all other forms of borrowing - auto loans, consumer loans, credit cards and commercial property - thus threatening to tip major western economies into recession.

"There is no real sign of improvement," said Francis Yared, interest rate strategist at Deutsche.

"We are probably closer to the end than the beginning in terms of US mortgage-related losses but regarding the process of recapitalisation and deleveraging, we're maybe half-way through."

Estimates of the eventual total for banks' losses and asset writedowns are as high as €1 trillion.

Even if it falls far short of that - the total declared so far stands at some €288 billion, and the IMF forecasts €641 million eventually - nobody expects a return to pre-August 2007 money market conditions soon, if ever.

The key stress indicator is the difference between unsecured three-month Euribor borrowing costs and anticipated central bank policy rates, or OIS, over the same period.

When credit boom turned to bust last year, London interbank offered rates (Libor) soared sending these spreads yawning to record levels of up to 100 basis points.

They have since narrowed, but only to around 74 basis points for dollar Libor/OIS, 68 bps for sterling and 63 bps for euro spreads - compared with levels around 10 basis points where they traded fairly consistently in the years before the crisis.

"Interbank funding is still tense," said a senior money markets trader at a large bank in London. "Liquidity is no better than it was six months ago."

The collapse of the market for repackaging and selling assets, known as securitisation, has left a gaping hole in bank funding.

This explains why the government securities repo market - secured short-term funding, typically overnight up to a few weeks - has taken up some of the slack recently. Indeed, the cost of repo funding has vaulted above some measures of unsecured funding, such has been the demand.

It's also why the ECB, Fed, SNB and Bank of England have taken extraordinary measures to get liquidity flowing through the banking system more freely again. Recent figures suggest banks need that funding.

On Tuesday the ECB's weekly long-term refinancing operation totalled 166 billion euro. Banks bid for almost a quarter of a trillion euro.

The US Fed's twice-monthly Term Auction Facility still provides banks with up to €96 billion in 28-day funds per month. It also has its Primary Dealer Credit Facility and Term Securities Lending Facility.

The BoE said its Special Liquidity Scheme, worth £50 billion, will run for up to three years.

All this to keep the wheels of the international money markets greased and help prevent another major banking failure like Bear Stearns in March.

"We do not know where the next explosion will occur," said David Kotok, chairman and chief investment officer at New Jersey-based Cumberland Advisors in a note to clients this week. "We do know it is coming."