Credit markets remain strained but show signs of thawing

Credit markets showed signs of thawing Thursday but remain far from normal.

In two signs of continued strain, a key bank-to-bank lending rate rose Thursday and the amount of commercial paper in the market fell for the fourth straight week to 15% below the level before the investment bank Lehman Brothers Holdings Inc. filed for bankruptcy.

While lending doesn't appear to be in the same seized-up state as last week, the year-end could prove a difficult time for funding as banks and other institutions try to get their books in order, said Kim Rupert, managing director of global fixed income analysis at Action Economics.

"It looks like the central bank's actions are starting to help marginally improve confidence enough where safe haven isn't the only thing on investors' minds," Rupert said. "But it's only one small step so far. It's going to be a very jagged type of improvement. There's still a lot of factors that are going to keep anxiety at elevated levels."

The London Interbank Offered Rate, or Libor, for three-month dollar loans rose to 4.75% from 4.52% on Wednesday. Just a month ago, three-month Libor was at 2.81%.

That stubbornly high Libor is just one of the reasons that the stock market has been tumbling. When banks are loath to lend, a weak economy has a hard time bouncing back. The Dow Jones industrial average sank nearly 679 points on Thursday to the lowest level in five years.

Libor's sharp jump over the past month is worrisome because consumer loans such as adjustable-rate mortgages are tied to Libor — meaning that those mortgages could become harder to pay. Citigroup analysts recently predicted that continued stress in Libor will result in a 10% jump in defaults for outstanding non-delinquent adjustable-rate mortgages when they reset.

Libor for overnight dollar loans slipped to 5.09% Thursday from 5.38%, but still remains extremely high — especially compared to the target Fed funds rate, a key overnight lending rate that the Federal Reserve slashed Wednesday by a half-point to 1.5%.

Meanwhile, commercial paper outstanding dropped for the fourth straight week. Commercial paper is a type of debt companies sell to get short-term cash, often so that they can maintain their inventories and payrolls. The Fed said commercial paper outstanding fell by $56.4 billion to a seasonally-adjusted $1.55 trillion in the week ended Oct. 8 — that's down from $1.82 billion on Sept. 10, and down 30% from the peak of $2.2 trillion in the summer of 2007.

As companies have a harder time getting financing, businesses and municipalities have been taking action to try to adapt. Connecticut's governor is requesting that banks statewide to contribute at least $1 million each to a lending pool for small businesses. And Apollo Management is offering a $540 million capital infusion to its affiliate Hexion Specialty Chemicals to help Hexion close its takeover of Huntsman Corp; Hexion said it doubted that Deutsche Bank and Credit Suisse Group would provide financing.

Automakers and dealers have been especially hard hit by the double-whammy of a slow economy and squeezed credit. Standard & Poor's Ratings Services on Thursday put General Motors and its 49 percent-owned finance affiliate GMAC on negative credit watch. It also put Ford Motor on negative credit watch. That means there is a 50% chance that S&P will lower the ratings on these companies in the next three months; S&P said that while their liquidity is adequate now, deteriorating conditions could challenge their liquidity in 2009.

There were a few promising signs that the stranglehold on the credit markets is starting to loosen, at least in some areas.

One was that the recent drop in commercial paper was smaller than the $94.9 billion decline in the previous week, and the $61 billion decrease in the week ended Sept. 24. And last week's decline occurred in financial companies' commercial paper and asset-backed commercial paper — commercial paper issued by non-financial companies edged higher overall.

"We're still seeing a lot of investments in overnights and very short maturities," said Alex Roever, a fixed-income analyst with JPMorgan. "The really strong financial and non-financial names — top tier corporations — are seeing stronger interest in one-month, two-month, three-month paper. It's definitely better than where it was a week or so ago."

Moreover, following the Fed's Tuesday decision to buy commercial paper and Wednesday's move to slash the key interest rate, the rates on certain overnight commercial paper fell by 1.15 percentage points on Thursday to 2.35%, noted Miller Tabak & Co. analyst Tony Crescenzi.

And IBM Corp. was able to sell $3.9 billion in longer-term bonds on the market Thursday after posting better-than-expected profits.

But investors are still anxious. The yield on the three-month Treasury bill initially edged up on Thursday, but then slipped to 0.58% from 0.63% late Wednesday. That suggests that demand for T-bills, regarded by investors as the safest assets around, remains high. The discount rate was also 0.58%.

Longer-term Treasury yields were mixed after the stock market's plunge.

In late trading, the 2-year Treasury note rose 1/32 to 100 28/32 and yielded 1.55%, down from 1.56% late Wednesday. The 10-year note fell 28/32 to 101 30/32 and yielded 3.76%, up from 3.65%. The 30-year bond fell 1 25/32 to 106 31/32 and yielded 4.09%, up from 4.05%.