Credit Markets Behaving Badly

I hate to beat this drum again, but the credit markets continue to act like they are increasingly spooked.

Bloomberg reports that Libor is on the rise again.

The London interbank offered rate, or Libor, that banks say they charge each other for three-month loans climbed to 1.33 percent yesterday, the highest level since Jan. 8 and up from the low this year of 1.08 percent on Jan. 14, the British Bankers’ Association said. The Libor-OIS spread, a gauge of bank reluctance to lend, increased to the most since Jan. 9.

It’s important to keep in mind that we are creeping up on the end of a quarter so there is going to be some excess demand as banks dress up their balance sheets. If that’s all that is work here then it might not be that big a deal. The fact, however, that the market gets bumped around with a little added demand is disconcerting.

The bigger question is whether the market is losing confidence in the ability of governments to resolve the problem. While a lot of credit market indicators have declined from their Fall highs the fact remains that they remain elevated. More to the point, the ongoing talk about rescue programs, de facto nationalizations of several big British banks and a general sense that resolution and clarity is far off are taking their toll.

“The market is beginning to think that the solution is either not politically possible, or we can’t afford it, or maybe there isn’t a solution,” said Bob Baur, chief global economist at Des Moines, Iowa-based Principal Global Investors, which manages $198 billion of assets. Libor’s rise “is just another indication of that concern,” he said.

The U.S. has committed about $10 trillion to combat the financial crisis that started in August 2007 as losses on securities tied to subprime mortgages caused credit markets to seize up. European governments have put up more than 1.2 trillion euros ($1.5 trillion) to protect their banking systems.

Rising Libor shows banks remain skittish 19 months later because they still don’t know if they can trust each other, said Soren Elbech, treasurer of the Inter-American Development Bank, a Washington-based lender to Latin American and Caribbean countries. Liboris used to calculate rates on $360 trillion of financial product worldwide, according to the Bank for International Settlements in Basel, Switzerland.

“Counterparty risk appetite is something that’s very much” on investors’ minds, Elbech said in a phone interview yesterday.

The lack of confidence inherent in those comments is startling. To me it conveys the sense that the system is broken, all that is holding it together is government support and the market participants are starting to doubt the ability of government to hold it all together.

The strains are starting to spill over into the corporate bond market as well. According to Bloomberg, the extra yield demanded on corporate bonds over treasuries was up to 8.09% yesterday versus 7.03% on February 11.

I’ve said before and I’m starting to feel very strongly that the improvements we have seen in the interbank market are illusory. They have been based on either implicit or explicit sovereign guarantees and an assumption that the situation was at least contained. But the players seem to be saying that not only do they still not trust each other but they’re beginning to doubt the guarantors of the system. Things could spin completely out of control here.

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