Interbank Rates And CDS Costs Hit By Impatience With Europe

The rate that European banks charge to lend to one another rose Monday along with the cost of insuring banks' debt against default, underscoring how these financial institutions still question their peers' financial
health while the region's fiscal crisis remains unresolved.

The spread, or difference, between a three-month interest rate on term deposits between banks in Europe and the overnight average reached 0.786% Monday, up from 0.7525% Friday, according to Bloomberg data.

That is triple the 0.2493% average from the first half of the year. The rate peaked in the last credit crisis at 2.069% on Oct. 10, 2008, after Lehman Brothers' collapse. The more banks charge to borrow over longer periods, the more negative their sentiment.

Spreads between the Euro Interbank Offered Rate (Euribor) and the Euro OverNight Index Average (Eonia) had begun to decline after the European Central Bank started buying Italian and Spanish bonds in early August, but they had been little changed since mid-August. Now, with rising anxiety over French banks' short-term funding and uncertainty about Greece's future within the EU, rates are elevated.

A lack of confidence in the region's ability to deliver a "unified and coordinated response to the crisis" is driving this, said Adrian Miller, senior vice president for fixed-income strategy at Miller Tabak Roberts Securities LLC in New York.

"As long as there is a risk of default, meaning euro banks will be subject to writing down Greek exposure, there will always be that question of capital adequacy among these banks," Miller added.

European financial institutions--particularly French banks--are among the most exposed to Greek debt.

A gauge of credit risk among European banks using derivatives also rose Monday, sending the annual cost of protecting their bonds against default up 11% to EUR290,500 ($396,074), from EUR262,000 as of Friday's close, according to data provider Markit.

Last week, the Standard & Poor's 500-stock index rallied on anticipation that European policymakers would announce further financial support for ailing member states and provide reassurance.

But investors are growing increasingly concerned that a meaningful rescue plan is far off, said Lawrence McDonald, senior director in credit sales and trading at Newedge USA. In turn, investors are reacting much as they did in 2008.

At that time, McDonald said, markets were conditioned to sell government-induced rallies until U.S. officials passed the $700 billion Troubled Asset Relief Program, or TARP, to buy or insure asset-backed securities caught in frozen markets.

"The European Central Bank has yet to do [something like] that," McDonald said, noting that "reaction to hoped-for progress in Europe is a pattern of 'up on euphoria and down on impatience.'"

Investors' expectations were fueled by the Group of Seven meeting Sept. 9; an unusual appearance by U.S. Treasury Secretary Timothy Geithner at the EU finance ministers' meeting in Poland last week; the U.S. Federal Reserve meeting Tuesday and Wednesday this week; and finance officials of the BRIC nations--Brazil, Russia, India, China and South Africa--meeting in Washington Thursday.

"It all goes back to the 2008 playbook," McDonald said. "These types of people rarely get together this often in such a short time period, so this raises the likelihood of a G7 backstop" to Europe's problems.

Geithner reportedly urged officials to expand a key piece of the euro crisis toolkit--the European Financial Stability Facility, or EFSF--in Europe's answer to U.S. initiatives like TARP, but he was met with some resistance.

The EFSF has EUR440 billion of buying capacity to support struggling euro-zone sovereigns, but "there have never been any discussions to expand the volume of the EFSF beyond [that] agreed effective lending capacity," said Guy Schuller, spokesman for Jean-Claude Juncker, president of the Eurogroup council of finance ministers.

Four countries have signed an amendment to widen the scope of the EFSF activity, and another 13 have said they will ratify it before mid-October. In that amendment, signed July 21, was an agreement to "improve the effectiveness of the EFSF...and address contagion," allowing it to "finance recapitalization of financial institutions" and "intervene in the secondary markets" when analysis by the European Central Bank suggests there are "exceptional financial market circumstances."

In light of worsening economic conditions, however, markets are behaving as though the facility's functionality--and size--may need to be reconsidered.