After Fed cut, debt market problems persist

The central bank's decision to cut interest rates has provided a boost of confidence, but how long will it last?

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- The Federal Reserve's half-point slash to interest rates jolted slumbering financial markets, but the debt markets will likely prove harder to revive.

Global stock markets cheered Tuesday after the central bank cut the target for a key short-term interest rate. On Wall Street, the Dow Jones industrial average, a broad index that tracks 30 large U.S. companies, surged 336 points, its biggest one-day point gain in nearly five years.

The move offered some relief to the beleaguered debt markets, which have been in disarray since ballooning problems in mortgages sent many debt investors fleeing to the sidelines. Still, most observers believe that it may be months before investor demand revs up again.

"Generally speaking, this has given markets a short-term shot in the arm. But the problems which still exist in the credit market are not going to go away just because the Fed has cut interest rates," said Peter Dixon, an analyst at Commerzbank.

Rates in the interbank market, known as Libor, eased after the Fed's move. On Wednesday, three-month dollar rates fell to 5.2375 percent, down from 5.58750 percent the previous day, according to the British Bankers' Association.

For the last month, the money markets have been a source of turbulence. Concern over the quality of assets backing short-term loans has seized up the buying and selling of commercial paper, a form of debt that banks, mortgage lenders and other companies rely on to raise money.

That's created a worldwide liquidity squeeze. Most recently, U.K. mortgage lender Northern Rock had to tap the Bank of England for an emergency line of credit when it couldn't raise funds the way it normally does in the money markets, triggering a run on the bank by nervous customers.

Central banks have poured billions into their markets to add liquidity. The Fed on Tuesday also lowered the rate it charges banks for temporary loans by half of a point - the second cut it has made to the so-called discount rate since August.

Reducing the discount rate lowers the penalty for banks to borrow directly from the Fed, but doesn't do much to jump-start lending among banks, said Charles Diebel, an analyst at Nomura International.

"The issue is still one of confidence," Diebel said. "In the short run this will help, but I'm not so convinced it fixes the longer-term problems."

Banks are getting squeezed by the credit storm on several fronts. They're on the hook for loans they have committed to finance leveraged buyouts. They also face problems with conduits, off-balance sheet investment vehicles they've established that issue commercial paper to make long-term investments. When there aren't any buyers of commercial paper, banks have to step in and lend funds to keep these vehicles going.

As long as banks have to shore up their liquidity positions to ensure they can deal with these demands, they are less likely to lend to anyone else, said Marc Ostwald, fixed-income strategist at Insinger de Beaufort.

The big Wall Street banks reporting third-quarter earnings this week have shed some light on how much they've suffered as a result of the credit rout. Morgan Stanley (Charts, Fortune 500) said Wednesday it took a $940 million loss on loans that had lost value, while Lehman Brothers (Charts, Fortune 500) on Tuesday reported a $700 million writedown on mortgage-related and leveraged loan investments.

While the banks' condition won't improve until investor appetite for debt is renewed, signs of life started to emerge even before Tuesday's Fed announcement.

After a quiet two months in the high-yield market, bankers sold $1 billion in loans used to pay for the leveraged buyout of auto parts supplier Allison Transmission last week. The first part of a $13 billion loan package tied to the takeover of payment processing firm First Data (Charts, Fortune 500) got underway on Monday.

The commercial paper market, which has contracted significantly since the start of August, has stabilized somewhat. The amount of outstanding paper has declined by about $270 billion since the end of July, when there was an estimated $2.2 trillion outstanding. But it has been doing so at a slower pace the past two weeks.

The Fed is expected to provide updated figures on the commercial paper market on Thursday, and attention will be focused on whether borrowers have encountered trouble refinancing their short-term loans.

"There are tentative signs things are starting to move, but people have been anticipating problems rolling over commercial paper. We're still at an early stage and there's still quite a lot to refinance," said Ostwald.

The Fed is anxious to restore stability to the credit markets, but it will take time to get them functioning normally. Ratings agency Moody's expects the repricing of risk to play out over the next six months.

"There is a lot of liquidity already in the banking system," it said in a report this month. "What is missing is fluidity and readiness to engage and trade." Top of page

Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.
Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.