Lack of liquidity, concerns over counterparty risk likely to persist.

(LONDON) Investors expect the global credit squeeze to continue beyond the first quarter of 2008, according to the Bank for International Settlements.

Models using derivatives based on money-market rates signal ‘expectations of a persistent lack of liquidity and lasting concerns about counterparty risk,’ the BIS said in its latest quarterly survey.

Basel, Switzerland- based BIS, formed in 1930, monitors financial markets and regulates banks.

‘The bank liquidity crisis has become a more serious problem than sub- prime though both are correlated,’ said Aaron Low, a principal in Singapore at hedge fund Lumen Advisors. ‘The banking confidence factor has affected a broader segment of the economy.’

Borrowing costs jumped in mid-August as banks, including Bear Stearns and Merrill Lynch, began to reveal losses on securities linked to US sub-prime mortgages. Concern that losses stemming from the collapse of the home-loan market will spread has kept lenders from offering money to all but the safest borrowers.

The three-month Euribor rate, the amount banks charge each other for loans in euros, is at a seven-year high of 4.9 per cent, 87 basis points over the Eonia three-month swap rate, the most since the inception of the euro in 1999. The median for the past 12 months is 6 basis points. A basis point is 0.01 percentage point.

Eonia is the euro overnight index average rate based on interest rates contracted on unsecured overnight loans in the region’s interbank market. Investors use swap contracts based on Eonia to hedge and speculate on short- term interest-rate movements.

Losses from US sub-prime mortgage foreclosures will probably reach US$300 billion, the Organization for Economic Cooperation and Development predicted on Nov 22. The slump in global credit markets may force banks, brokerages and hedge funds to cut lending by US$2 trillion and trigger a ’substantial recession’ in the US, Goldman Sachs forecast on Nov 16.

The credit squeeze and concern about a global economic slowdown drove investors to the safety of government debt in the last quarter, pushing yields on 10-year Treasuries to 3.79 per cent on Nov 26, the lowest since March 2004.

‘Government bond yields in major industrialised economies fell as investors fled to safety, but also as a result of an anticipated weakening of economic activity,’ the report said. ‘Heightened expectations of monetary easing, in particular in the US, added to the decline in yields.’

The difference between the cost of borrowing by banks for three months and that of the US government has widened, indicating risk-averse investors favour the safety of bills over the money markets.

The so-called TED spread, the difference between three-month Treasury bill yields and the London interbank offered rate, reached 2.16 percentage points on Nov 29. That was the widest in more than three months. The spread was at 2.06 percentage points on Monday.

Fed funds futures traded on the Chicago Board of Trade suggest that investors see a 26 per cent chance of a Federal Reserve cut in its benchmark rate to 4 per cent from 4.5 per cent at its latest rate-setting meeting. The contracts suggest a reduction of at least a quarter-point is a certainty. — Bloomberg

Source: Business Times