Fed, ECB vow to offset Y2K-style year-end credit squeeze

he Federal Reserve announced Monday steps to keep cash flowing before banks shut their books at year's end.

The European Central Bank also promised banks extra money to tide them through a likely severe year-end cash squeeze, mirroring action conducted around the turn of the millennium.

The Fed said it would move up the timetable for its regular lending and lengthen the loan periods to banks. It also assured markets that it would keep enough money in the system to maintain its target for short-term interest rates.

Such steps have been taken before, including as recently as 2005, when banks faced pressure to maintain their reserves. But the action Monday drew attention given the unease in financial markets.

"The Fed wants to make absolutely certain that nobody thinks they are going to drop the ball," Action Economics chief economist Michael Englund says.

As fallout from the U.S. subprime mortgage collapse spreads and banks hoard cash to offset balance sheet strains, interbank lending rates in euros, dollars and sterling have once again surged to well above central bank targets over the past week — forcing the Fed and ECB to assure banks of available funds.

The ECB reiterated its intent to ease the year-end strain, where two-month euro London interbank rates (Libor) are at their highest since 2001 and three-month rates had their biggest one-day jump on Monday since the credit crisis erupted in August.

"The ongoing process of risk appraisal and repricing in financial markets could be more protracted than previously expected and could have a broader impact on financial markets and the economy," ECB Vice President Lucas Papademos said Monday in a speech at the Cypriot central bank.

The Fed later echoed the ECB promise of extra funds and said it would conduct a series of term repurchase agreements extending into the new year, the first for about $8 billion set for Nov 28 and maturing on Jan 10, 2008. Repurchase agreements, or repos, are a form of short-term borrowing for dealers in government securities.

"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 who declined to be named. Two-month and three-month dollar Libor rose to their highest in a month on Monday. At more than 50 basis points, the spread between three-month dollar Libor and the 4.5% Fed funds target rate was at the widest since the crisis began.

Banks say more funds are needed. Fourteen out of sixteen euro money market traders polled by Reuters said the ECB will need to provide more liquidity than usual to stabilize money markets for at least the next three months.

"Uncertainty about potential additional provisions and unwanted increases in balance sheets increases the traditional year-end tension in money markets," analysts at Societe Generale said in a note to clients.

"This raises the prospect of stress at similar levels to Y2K," they added, referring to central banks' flooding of banking systems with cash at the end of 1999 amid concern about systemic problems from possible computer failures.

Now, the virtual shutdown of asset-backed commercial paper markets amid uncertainty about U.S. mortgage assets has forced banks and their special vehicles to turn to the interbank market for funds just as cash hoarding has meant few want to lend.

HSBC Holdings hbc on Monday highlighted the nature of the stress and said would take its two structured investment vehicles (SIVs), Cullinan and Asscher, onto its balance sheet to avoid a forced sale of their underlying assets.

HSBC said it hoped the move would restore some confidence to the sector whose access to short-term funding has been severely limited since the credit crunch bit earlier this year.

Goldman Sachs downgraded HSBC shares to 'sell,' saying HSBC would probably need to set aside a further $12 billion against losses on U.S. mortgage debt, in addition to providing up to $35 billion in backing for the investment vehicles.

But while absorbing troubled SIVs onto bank balance sheets might be the endgame of this latest financial crisis, analysts said it will tie up capital that would otherwise be lent out. And that is the route by which the underlying economy feels the heat from what has been a mainly financial blowout to date.

Clamor for more official action has increased as a result.

"Without stronger policy responses than have been observed to date ... there is the risk that the adverse impacts will be felt for the rest of the decade and beyond," former U.S. Treasury Secretary Lawrence Summers wrote in Monday's Financial Times.

And some analysts said that if the real economy is now threatened, active central bank liquidity management alone may not be enough and more interest rate cuts may be needed.

"While the ECB has been very proactive in its liquidity provisions, it separates that from its monetary policy decisions," said Eoin O'Callaghan, economist at BNP Paribas.

"But the only way you can separate the two is if you believe the financial market problems do not affect the real economy. Now that's becoming less and less of a fair assumption."

Meanwhile Britain's main casualty in the global credit crisis, Northern Rock, found a potential rescuer.

Northern Rock said a consortium led by Richard Branson's Virgin Group was its preferred bidder and planned swift repayment of 11 billion pounds ($22.6 billion) of emergency lending from the Bank of England.

The French bank hardest hit by the market crisis, investment bank Natixis, on Sunday put the cost at 407 million euros ($602.6 million) for its third-quarter results.

Contributing: Barbara Hagenbaugh, USA TODAY; Reuters