Money markets funding options wane as debt crisis intensifies

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* 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.