* Funding doors quietly close as debt crisis ramps up* Short and longer-term funding dwindling* But ECB liquidity should tide banks overBy Kirsten DonovanLONDON, April 11 The latest escalation of the euro zone debt crisis, with Spain now taking centre stage, is closing funding markets for banks again on concerns over exposure to the large amount of sovereign debt now being hoarded by some institutions. Spanish and Italian bond yields have risen sharply over the last week as the effects of the European Central Bank's three-year liquidity operation wear off and worries about Spain's ability to meet its budget targets and fund itself grow. That means banks that used the ECB's cash to buy bonds issued by their own governments may be looking at losses if they need to sell that paper to repay debt."If you parked the ECB cash in government bonds then you're losing money if you need to sell them to repay your own bondholders," said Rabobank rate strategist Lyn Graham-Taylor.
"That has to worry banks. Effectively sovereigns and banks in Spain and Italy have become ever more closely tied together through the (ECB's three-year tenders)."Spanish banks' holdings of government bonds rose by almost 70 billion euros from the end of November to the end of February, while Italian banks' holdings have risen almost 55 billion euros, according to ECB data. Fears over individual bank exposure to the euro zone debt crisis was behind a shut-down in funding markets in the second half of last year, and traders said the pick-up in unsecured interbank lending that had been seen since January had partially reversed. Lenders were again becoming pickier who they give cash to, they added. Doors to longer-term funding markets have also quietly closed again, not only to banks in Spain and Italy but also to some corporate issuers in the two countries.
"We shouldn't put the weakness at the door of illiquidity or the Easter break, but more at Spain's door," said Societe Generale credit analyst Suki Mann."The speed at which the market has unwound, propagated by higher peripheral bond yields, is illustrative of how important it is that we contain Spain. To this end, decisive action somewhere needs to be taken."On Tuesday, Bank of Spain Governor Miguel Angel Fernandez Ordonez said Spanish banks, already hurting from a property crash, could need more capital if the economy continues to deteriorate and they face a new wave of loan defaults. Reflecting those concerns, the cost of insuring against a default by Spanish bank Santander - seen as one of the country's strongest - has risen around 25 basis points in April, according to 5-year credit default swap prices from Markit . For BBVA it is around 70 basis points higher.
Another risk as sovereign bond yields rise is that margins in the repurchase (repo) market, where banks use government bonds as collateral to access cash, may rise, making it a less effective way of funding. Clearing House LCH. Clearnet cut its margin rate on Spanish bonds just three weeks ago, citing the fall in the yields seen since the beginning of the year, but it has not adjusted Italian margins since raising them in January."(A margin rise) would undeniably have an impact but probably but less so than similar hikes have done in the past," said ICAP strategist Chris Clark."The market will be more prepared for it this time around and also there seems to be less active positioning in repo markets these days."Also, banks holding Spanish and Italian government bonds aren't as reliant on the repo market for funding since the ECB's massive three-year liquidity injections, Clark added. With money market curves virtually flat, banks are tending to only enter into repo trades overnight as there is no premium for lending longer-term. For example, the overnight rate for Spanish general collateral repo was last seen at 0.33 percent, according to ICAP, with the three-month rate at 0.35 percent.
* Bill rates, repo collateral rates, show easing in markets * Interbank lending rates steady ahead of ECB 3m tender * Strong demand for ECB liquidity could spark more worries By Emily Flitter and William James NEW YORK/LONDON, Feb 24 U.S. money markets closed out the week with an easing of conditions both in the repo and short-term Treasury markets, where demand for securities showed new slack. The extreme conditions that were present earlier in the week in the repo market, where five- and seven-year Treasury notes were trading as repo collateral at dramatically negative rates on Tuesday and Wednesday, eased further on Friday. In the Treasury bill market, rates rose as demand ebbed for the extreme safe-haven, very low-yielding securities. In both cases, new supply seemed to be the source of the market move. The Treasury Department sold $35 billion in new five-year notes on Wednesday and $29 billion in seven-year notes on Thursday. Both auctions drew strong demand and a lower-than-expected yield, forcing Treasury traders to buy more securities outright and borrow fewer of them in the repo market. The Treasury Department announced a $20 billion sale of 49-day cash management bills on Thursday. The coming sale will add more supply to the short-term bill market. In addition, the Federal Reserve sold short-term Treasuries twice this week, also adding to the supply. Tom Simons, money-market economist at Jefferies & Co In New York, said the Treasury's CM announcement seemed to have a noticeable effect on the short-term market. "The whole bill market is a little bit heavier because of this increased supply," he said. "I think it's possible we could get another mid-April maturity CM sometime soon so that would put further pressure on the market." AWAITING ECB TENDER Meanwhile, interbank markets will remain in the thrall of broader investor risk appetite next week as the European Central Bank reveals demand for its three-year loans, with a high take-up likely to buoy sentiment and push lending rates lower. Financial markets will be holding their breath on Wednesday when the ECB unveils how much three-year cash banks have borrowed in the second, and possibly last, ultra-long lending operation. In a bid to alleviate bank funding pressures the ECB has loosened collateral rules and temporarily opened up unlimited access to long-term loans, a move that has also soothed spiking tensions in the sovereign bond market. In the past, interest in central bank liquidity operations has been limited to money market experts seeking to gauge the impact on short-term interest rates. The traditional dynamic was the greater the excess cash, the lower rates would fall. But in a system already swimming in more money than it needs, bank-to-bank lending rates are now more likely to rise or fall depending on whether the refinancing operation boosts support for the euro zone's ailing sovereign bond market. The latest Reuters poll points to a demand of 492 billion euros at the long-term refinancing operation (LTRO). WHEN THE DUST SETTLES Looking beyond the assumption that above-consensus demand would push rates lower at first, analysts saw some risk that the move would not be sustained. "If there's a big number it could be an initial positive reaction by the market, but then they will turn to looking at the crisis from a more fundamental perspective and whether this is enough to turn it around," said Elwin de Groot, senior market economist at Rabobank in Utrecht, the Netherlands. "In our view, we need more measures by European leaders to do that, so it could well lead to more negative market sentiment in the days following - even if there's a big take-up." Demand well in excess of the consensus may also raise broader economic concerns: in the first instance that banks were in worse health than the bullish market had assumed, before more structural worries come to the fore. "That (knee-jerk) may move into a concern that banks might not be focusing on core business quite as much," said Peter Chatwell, rate strategist at Credit Agricole in London. "Ultimately, to improve the macroeconomic environment we need banks not just to be full of funding, but looking to take real economy business opportunities."