(Business Law Currents) Debt and capital market transactions are turning ugly as they show the stain of a growing liquidity and collateral squeeze. With markets behaving badly, are we about to see credit crunch 2.0? A review of European filings has some troubling implications.

Last week the world turned upside down as German bonds, the once safe haven of Europe, lost their allure and German 10-year yields rose above those of the U.S. on fears that the Eurozone leaders may be impotent in the face of crisis.

The result was Germany’s worst bond sale since the launch of the Euro, as it failed to cover one third of the amount (around €2 billion) it sought to raise, leaving the Bundesbank, the country’s central bank, to pick up the pieces.

The fall from grace of Germany only highlighted the growing cracks appearing in the world’s financial system and these cracks extend well beyond Germany. A review of FSA filings reveals that UK banks are being starved of credit with virtually no UK bank instigating a debt programme in the last couple of months, despite an explosion in structured note programme filings.

Paucity of Bonds

According to data compiled by the Financial Times, European banks sold just $413 billion worth of bonds this year, equivalent to just two-thirds of the $654 billion that is due to be returned to investors in 2011 - a shortfall of $241 billion that banks must find in the coming months.

This paucity of bonds correlates with distress signals from both Moody’s and Standard and Poor over the credit rating of banks around the world. This week, Moody’s placed the junior debt of 87 banks in 15 European countries on review for a possible downgrade and Standard & Poor downgraded everyone from Bank of America to Barclays following a revision of its risk weightings to allow for the fall from grace of sovereign debt and a growing liquidity crunch.

The downgrade prompted Citigroup to disclose that its cost of funding would increase by around 1 per cent and saw credit default swaps (CDS) on Bank of America rise 21 basis points and Morgan Stanley CDS prices hit 503 basis points - a cost of $503,000 to insure $10 million of Morgan Stanley bonds.

Repo Rescue

With bond markets shut and investors still wary of asset-backed securities, many banks have become increasingly reliant on the repo markets as a way to generate money. Repo markets have, however, started to show the strain.

By way of background, repos are used by many banks as a way to increase liquidity and involve the sale of a security (e.g. bonds) together with an agreement for the seller (e.g. the bank) to repurchase the securities at a later date. In return for “selling” the securities, the seller receives a purchase price with an agreement to repurchase the securities at a later date and probably for a greater price – effectively representing the “interest” (known as the “repo rate”). A repo is the economic equivalent of a secured loan with the buyer receiving securities as collateral and the seller receiving the purchase price as the loan principle.

Although repos can be abused by firms to massage balance sheets, as in the case of Lehman, they have also proved a valuable life line for banks to generate liquidity, particularly in times of stress.

The repo rescue may be about to end though. Repo rates have been falling as they did in 2008, as banks become more and more critical over the assets they will accept as collateral.

In the topsy-turvy world of repos, the more attractive the underlying value of the collateral backing a loan, the lower the repo (interest) rate. During extreme situations, such as the credit crunch of 2008, the repo rate can turn negative- meaning that borrowers were actually paid to deposit their assets with other firms. Akin to a bank paying you to take a loan.

Following the introduction of the Term Securities Lending Facility (TSLF) on 11 March 2008, debt markets came under unprecedented stress, causing repo rates to plunge on U.S. Treasury overnight general capital and widening the spread with other assets, as banks sought out only the highest quality capital for their lending.

To address the widening spread in repo rates between Treasury general capital and other assets, TSLF intervened in the markets by increasing the supply of Treasury collateral. This was achieved by allowing banks to swap less liquid collateral for U.S. Treasuries.

TSLF’s intervention peaked in the market in late 2008 at $200 billion before falling back and finally expiring in February 2010 as the spread between repo assets normalised. The return to normalcy was achieved by increasing the supply of highly sought after Treasuries, whereby an increase in their supply pushed up the repo rates as repo lenders found that there were enough high quality assets to go around.

Germany’s recent short term repo rates have shown a worrisome similarity to those of the U.S. in 2008. Germany’s repo rates have moved markedly lower over the last year as the repo supply of German bonds in the system dries up. With less and less banks willing to lend German bonds to each other, the repo rates have plummeted and now sit significantly lower than repo rates on Belgium or France bonds.

Potentially reflecting a bet on the Eurozone disbanding, (German bonds would likely be worth markedly more than their Eurozone cousins) the lower rates demonstrate the reluctance of banks to hand over high quality assets at a time of heightened counterparty and sovereign default risk.

An End to Sterlisation

The unwillingness of banks to lend to each other was confirmed recently by another high profile European failure. According to Reuters, for the first time in six months the ECB failed to offset the extra liquidity created from its bond purchases (known as “Sterlisation”) this week in a sign of mounting tensions in Eurozone banks.

Reuters also noted that 85 banks bid a total of €194.2 billion for seven-day term deposits, but fell short of the €203.5 billion euros of bond purchases created by the ECB.

By way of background, the aim of the ECB’s sterilisation is to drain the extra money out of the markets that is created by the ECB purchasing bonds. The idea being that the ECB can intervene to support the price of Eurozone bonds without increasing money supply (i.e. Quantitative Easing). Unfortunately, in its failure, the lack of sterilisation has left an additional €8.6 billion in the system.

Perhaps, worse still, the failure underlines the reluctance of banks to lend to each other and that banks would rather hang onto very liquid sources of finance, such as overnight funding, than take advance of the attractive weekly ECB funding. With repo rates on high quality assets plummeting and bond markets frozen, can you blame them?