Interbank lending woes or...

Derivatives Traders Signal Bank Woes Likely to Worsen (Update3)

By Liz Capo McCormick

June 4 (Bloomberg) -- Interest-rate derivatives traders are betting banks' difficulties obtaining cash to fund holdings and shore up balance sheets will worsen.

The difference, or spread, between the three-month dollar London interbank offered rate and the overnight index swap rate on contracts beginning in three months and trading now in the forwards market is greater than spreads on those starting this month, according to data tracked by Credit Suisse Holdings Inc.

``The movement in the forward Libor-OIS spreads is telling you that the market is concerned that things can get even worse before they get better,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse, one of the 20 primary dealers of U.S. government securities that trade with the Federal Reserve. ``Until all banks' balance sheets are cleaned up and they've re-capitalized, there is going to be funding pressure.''

Derivatives trades show that while global markets have rebounded since March, the worst may not be over for banks after racking up $387 billion of losses and writedowns from mortgage- related securities since the start of last year. Lehman Brothers Holdings Inc. has tumbled about 19 percent this week on concern it needs outside funding to shore up its balance sheet.

The three-month Libor-OIS spread traded forward to June 16, the date the June Eurodollar futures contract expires, is 68.5 basis points, while the forward spread corresponding to the September Eurodollar expiration is 70 basis points, or 0.7 percentage point. Eurodollar futures are priced at expiration to three-month dollar Libor.

Availability of Funds

Overnight indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For U.S. dollar swaps, the floating rate is the daily effective federal funds rate.

The difference between Libor, which is an average rate based on a daily survey of 16 banks by the British Bankers' Association, and the OIS rate indirectly measures the availability of funds in the money market. Forwards give expectations for the future.

Wider Libor-OIS September spreads may reflect traders exiting ``soon-to-expire'' positions earlier than usual, given potential volatility in Libor amid questions over its veracity, according to Laurence Mutkin, London-based head of European fixed-income strategy at Morgan Stanley, another primary dealer.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events, such as changes in the weather.

Widening Forward Spreads

The market has grown more pessimistic since April 30, when the September spread was 6 basis points less than June, according to Credit Suisse.

The spot three-month dollar Libor-OIS spread is 67 basis points today, after ranging from 24 basis points to 90 basis points this year and peaking last year at 106 basis points in December. The spread averaged 11 basis points for the 10 years prior to August, when the global credit crunch began.

Concern institutions are having difficulty accessing financing increased this week after Standard & Poor's lowered credit ratings for Morgan Stanley, Merrill Lynch & Co. and Lehman Brothers on June 2, citing the possibility that the investment banks will have further writedowns on devalued assets.

Lehman Options

Lehman, the fourth-biggest U.S. securities firm, may report this month its first quarterly loss since going public in 1994, increasing pressure on the company to raise capital, according to analysts at Oppenheimer & Co. and Bank of America Corp. Lehman may be forced either to sell all or part of itself to a bigger financial firm or sell a large quantity of new shares to bolster its finances, the Wall Street Journal reported today.

Options trading shows bearish positions on Lehman exceeded bullish ones by 1.6-to-1 yesterday, a two-month high. The cost of protecting debt sold by Lehman from default rose to 240 basis points from 150 basis points in the credit-default swaps market during the past week, data compiled by UniCredit SpA show.

The British Bankers' Association has been under fire since the Bank for International Settlements said in March the banks that set Libor understated their borrowing costs to avoid speculation they were in financial straits as losses in credit markets mounted.

Libor Oversight

The London-based BBA completed a review of Libor on May 30, saying it will strengthen ``oversight'' of the system. Details will be revealed ``in due course,'' it said.

Three-month Libor-OIS forward spreads through December maturities are in line with each other, indicating the problems with Libor will be longer lasting, according Mustafa Chowdhury, head of U.S. interest-rate research in New York at Deutsche Bank AG, also a primary dealer.

``Instead of being an immediate bank-liquidity problem, Libor is now being affected by a longer-term capital problem,'' Chowdhury said. The market ``had previously expected the liquidity problems that had boosted the Libor-OIS spread to dissipate relatively quickly.''

The Libor-OIS forward spread that corresponds with the Dec. 15 Eurodollar futures expiration date was 67.5 basis points.