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Central banks rush to keep system solvent in crisis

Central banks rush to keep system solvent in crisis NEW YORK, Central banks across the world scrambled to meet desperate demand for cash on Friday, just a day after Washington Mutual collapsed in the largest ever U.S. bank failure. As investors focused on the prospect of a $700 billion bailout for Wall Street, the European Central Bank, the Bank of England and Swiss National Bank collectively put up $74 billion of one-week funds into the markets.

The Federal Reserve was actually forced to drain some of its recent reserve injections to keep its overnight borrowing target at 2 percent.

Banks were finding other ways to tap into Fed loans, borrowing a record $187.75 billion per day on average directly from the central bank -- four times the previous record set one week earlier. Global money markets dried up, forcing increased injections of cash from central banks as dollar borrowing rates remained high, particularly for three-month money. The market"s stress was aggravated by the looming quarter-end next week.

As they worry about potential exposure to downtrodden real estate assets, banks and other financial services companies are generally worried about lending to one another despite the best efforts of monetary authorities.

"The markets are just caught like a deer in the headlights, watching Washington, trying to figure out what the next step is," said Boris Schlossberg, director of currency research at GFT Forex in New York. The key three-month Euribor rate jumped to the highest level since early 1995, hitting 5.142 percent. The interbank cost of borrowing 3-month dollars was broadly unchanged, according to the British Bankers Association"s latest daily fixing.

But the spread of three-month London interbank offered rates over OIS rates -- which expresses the three-month premium paid over anticipated central bank rates and is seen as a gauge of banks" willingness to lend to each other -- hit a record high 202 basis points from Thursday"s 197. The U.S. Treasury market reflected the yearning for safety, with two-year notes surging 9/32 and offering a yield of just 2.04 percent.

PERHAPS THE ONLY GAME IN TOWN Stress was exacerbated by the approach of the quarter-end. Any three-month lending will then mature over the Christmas period, when markets are either closed or highly illiquid. "These operations are designed to address funding pressures over quarter-end," said a statement from the Federal Reserve, which expanded dollar swaps facilities with other central banks. "Central banks continue to work together closely and are prepared to take further steps as needed to address the ongoing pressures in funding markets."

With commercial banks everywhere hoarding cash, central banks were almost the only game in town. Uneasiness intensified after Republicans balked at Treasury Secretary Henry Paulson"s plan to buy bad debt from banks and instead floated an idea of their own for mortgage insurance. The Reserve Bank of Australia launched its first-ever repurchase operation in U.S. dollars and all $10 billion on offer was hungrily snapped up. The RBA established a U.S. dollar swap line with the Fed earlier in the week.

In South Korea, the Finance Ministry said it would inject $10 billion or more into the local swap market until the middle of October to stave off persistent dollar funding shortages. The RBA and the Bank of Japan also kept adding extra cash to their own banking systems on Friday. (Reporting by Pedro Nicolaci da Costa, Marc Jones and Wayne Cole; Editing by Jan Paschal)

Pedro Nicolaci da Costa
Friday September 26 2008
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