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Credit Squeeze Tightens Grip

The Fed's promise of liquidity did little to ease credit markets' pain.

Round two of 2007's credit crisis has twice the sting.


Federal Reserve's

reassurance Monday morning that it would shore up liquidity in the financial system as banks face their year-end crunch did little to thwart the brewing seizure in the credit markets.

Instead, the Fed stoked more fear and led traders to compare the current market environment to the anxious days and months in 1999 leading up to the turn of the calendar to the new millennium.

The New York Fed

announced Monday morning it will respond to "heightened pressures in money markets for funding through year-end" with a series of repurchase agreements that are more long term than usual.

The first, announced Monday, is an $8 billion, 52-day injection. Details and timing of further operations through the rest of the year are not yet available, according to the Fed's statement. Typically, the Fed puts liquidity into the system in 14-day increments.

In the wake of the Fed's announcement, news spilled into the market about banks' balance sheet woes, including



moving two structured investment vehicles onto its balance sheet and about


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mortgage market exposure. Stock market indices hit lower lows Monday as Treasury bond prices soared.

Traders in junk bonds and leveraged loans report illiquid markets and rising risk premiums well beyond August's worst moments. Investors say that the repeat of the summer's credit crunch is worse this time around, because recession is now widely considered a more tangible possibility, as mortgage-rate resets in 2008 threaten a consumer spending slowdown.

The Fed, for its part, was trying to prevent markets from "completely freezing," says Ethan Harris, chief economist at Lehman Brothers.

"Given the high level of attention focused on the coming year end, we hope to reassure market participants of our commitment to providing sufficient balances at that time by starting to provide those balances now," said a New York Fed official.

The Fed also reassured markets by noting that its trading desk "plans to provide sufficient reserves" to battle upward pressures on the federal funds rate. In other words, the Fed will provide liquidity to the market to keep banks lending to each other at the Fed's current target rate of 4.5%. According to the New York Fed Web site, the effective fed funds rate, or the real rate at which banks have been lending to each other has been elevated for the past two weeks. That means banks are hoarding cash in an unpredictable market environment, anxious about their ability to maintain reserves, and charging premiums to other banks for overnight money.

"There's definitely a scramble for liquidity," says Harris. "We're far from out of the woods in terms of this difficulty in capital markets."

The Fed's reassurance comes as banks and other financial institutions face a year-end pinch for capital as they attempt to cleanse their balance sheets of their most unsavory assets before reporting final results.

Banks like Citigroup and

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, in particular, have come under scrutiny recently regarding their ability to maintain capital reserves given their high level of exposure to the subprime mortgage market amid tighter lending standards.

But they are not alone. Many investment banks' attempts to sell over $200 billion in leveraged loans stockpiled from the first half of 2007's M&A boom also have stagnated, as investors still are smarting from falling prices on recent new-debt issues like those of

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, say loan and bond market participants. Likewise, high-yield bond market investors say they're reluctant to take on any new risk with the threat of recession and rising defaults looming. As lending costs rise, companies face more difficulty refinancing or paying off debt, much less growing.

Junk-bond risk premiums widened Monday to their broadest level since August 2003, according to KDP Investment Advisors, a high-yield research and advisory firm. Financing deals for the buyout of


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recently faltered in the corporate debt markets.

Worries sent investors seeking the relative safety of Treasury bonds, where yields reached new multiyear lows. The yield on the 10-year Treasury note has dropped to 3.85%, about 17 basis points below Friday's closing yield, and a level not seen since 2004. The 30-year Treasury note yield fell to 4.28%, its lowest since 2003.

"The phrase that keeps coming up on our trading floor is, 'We're looking at Y2K here,' " says T.J. Marta, fixed income strategist at RBC Capital Markets. He's recalling the last time fixed-income markets were so fearful of a liquidity crunch that the Fed intervened with larger, long-term liquidity injections to promise stability.

Marta's trading floor is not so far off. The Fed has done longer-duration year-end liquidity operations in past years, though this is the largest single long-term repo since the days before Y2K. Then the Fed announced 90-day open market operations, an expansion of collateral accepted by the Fed for liquidity, and a "Standby Financing Facility" to ease in the new millennium for the banking system.

The most recent long-term operation was a 28-day, $5 billion operation in December 2005, a $4 billion, 52-day operation in November 2004, and two $4 billion operations in 2003, according to New York Fed records.

If traders are right, and this is Y2K redux, the market panic will be for naught. Too bad the mortgage resets can't just come and go like New Year's Eve.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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