Why the jittery in money markets?

Escrito el 13 agosto 2007 por Juan Toro en Financial Markets

Thursday 9th of September the cost of borrowing money overnight in euro money markets rose above 4,62 % -highest level in six years-. This led the ECB to intervene and provided over 95 billions euros to the banking system. The following day the ECB continued its intervention providing additional 61 billions in money for the weekend. Other Central banks such as the Federal Reserve in the US, the Bank of Japan and the Australian central bank did also provided needed liquidity to fine tune overnight rates (and other short term rates in money markets) on Thursday and Friday. The first thing that needs clarified is that those fine tuning operations pursued a reduction in an undesired credit risk premium that has taken the short money rates to skyrocket levels. Over the 9th and 10 th of August there was liquidity in the money markets but at unwanted price. Banks were willing to borrow/lend money among each other but at a rate that was far away from the target followed by the corresponding Central Banks. Any spread between the target rate of the corresponding monetary authority and the realized rate was due to a risk aversion among banks that demanded a higher rate due to fears on the unknown credit position of other banks (their counterparties). The question that comes to mind is why this fear? Why did banks mistrusted each other?

One theory that has been told is the commitments by some banks to provide credit lines to asset back credit arbitrage funds. These funds buy long term asset backed securities (say CDO tranches that have subprime loans as end collateral) and finance it with short term commercial paper that have to roll every time the short paper expires. In case these funds ever have a problem in the commercial paper market they agree with a bank a credit line that can be used whenever needed. Current stress in the commercial paper market might have forced some funds to make a call to these credit lines due to their inability to access financing at reasonable rates. If the end destination of the funds demanded in money markets by some players on Thursday and Friday mornings was the use of these credit lines, then this explains why many banks did not want to lend money for that type of financing at the normal cost of money. No one wanted to be on the side of an operation that was engineered to refinance and asset backed security very much disliked these days.


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