The Credit Crunch Reaches the Money Market

David Gaffen notes today that a large spread is opening up between overnight Libor and Fed funds. With overnight Libor now at 5.86%, that's 61bp wide of the Fed funds risk-free overnight rate – a spread which, according to Gaffen at least, is mostly made up of a credit risk premium. That's scary, because if banks are requiring a 61bp premium to lend to each other overnight, the interbank credit market – which is crucial to the smooth functioning of the financial system – is prone to seizing up entirely.

And the WSJ also reports today that money-market funds – that other important source of liquidity – are suddenly discovering nasty bits of subprime where they were least expected. The culprit is something called asset-backed commercial paper, which is normally backed by bank liquidity. But right now it's looking decidedly less liquid than one might hope, if you're a money-market fund:

The problems for the asset-backed commercial paper market began earlier this week when three conduit vehicles said they wouldn't be able to redeem paper coming due and instead would have to extend the maturity of the notes...
"This is supposed to be the most highly liquid portion of the market," says Jon Thompson, investment officer of structured finance at Advantus Capital Management, which has $18 billion in assets, including money-market funds. "The fact that some residential mortgage-related conduits have stopped issuing paper and some are extending past their maturity dates signals you're in the first part of some trouble."

This is definitely bad news. Investors in obscure asset-backed instruments knew, or should have known, that they were taking liquidity risk. But the interbank market and money-market funds are designed to be as liquid as possible. If they're drying up as well, we can be quite sure that this particular credit crunch is not being "contained".

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