It wasn’t fears of default that froze interbank lending this month, says Martin Hutchinson. Top quality banks were paying the same interest as the most vulnerable banks, as the entire sector was forced to deleverage. Martin says the US Treasury’s $250n capital injection should help the market identify the strongest banks. Once that happens, expect these stocks to rebound strongly.

This from Money Morning:

Late last year, when it became clear that the LIBOR market was seizing up, I wasn’t surprised, given all the credit problems in the banking system. After all, if the market perceived banks as suddenly riskier, you would expect the differential between three-month LIBOR and three-month Treasury bills to widen, as lenders demand higher rates from the newly riskier banks.

However, you would also expect the rate differential between banks to widen as it did in 1974 – you would expect LIBOR for the top quality banks to be well below the rate for the competitors.

Of course, that’s not what has happened. Three-month LIBOR is roughly 4% more than the yield on three-month T-bills. But there’s much less differentiation between LIBOR for different banks – in general, we’re talking about only a quarter percentage point from top to bottom.

What’s more, when the U.S. Federal Reserve auctioned $150 billion of three-month money last week at 1.4% – far below LIBOR – it wasn’t taken up. If credit risk were the problem, that would make no sense: You could pick up more than 3% per annum by borrowing from the Fed and lending to a bank you trusted.

Clearly, credit risk isn’t the problem. Banks aren’t worried about a possible default of JPMorgan Chase & Co. (JPM); they just don’t want to make interbank deposits at all, because they are trying to reduce leverage.

Banks borrowed too much money in relation to their capital during the bubble years, so their leverage (roughly their total assets to tangible stockholders’ capital) got too high.

That high leverage makes a bank more profitable in good times, but it increases a bank’s risk in a downturn, because each dollar of capital has to support the losses on $15, $20 or even $30 of assets. Since last fall, banks have suffered losses on holdings of low-quality debt, which has reduced their capital. At the same time, they have been forced to take back onto their balance sheets assets that they had thought were safely parked in “Structured Investment Vehicles,” or SIVs, that were funded with commercial paper – and now the asset-backed commercial paper market has cratered.

Now, banks’ best corporate customers are coming to them for commercial loans, because the commercial paper market in general has run into trouble – more assets banks really don’t want.

With their assets being forced up and their capital down, banks must reduce their leverage fast, either by reducing assets or by increasing capital – or, ideally, both. Otherwise, the market will view banks as being too risky – a distortion that will boost their borrowing costs and decimate their profits.

One way to reduce leverage is to avoid participation in the interbank market, which is a low-margin business that increases assets without doing much for income. At the same time, even cheap short-term liabilities aren’t that attractive; long-term debt (to improve their liquidity position) and proper capital is what banks need.

As I’ve noted before, the $700 billion Troubled Assets Relief Program (TARP) passed by Congress addressed the wrong problem. By buying $700 billion of banks’ lowest-quality assets, the TARP would reduce those institution’s assets by only the same $700 billion. It might even damage their capital position, if the banks were forced to write down the assets further and to then sell them to the TARP at a loss. In that form, the program would do very little for banks’ No. 1 problem: Their leverage.

Under a revision engineered by U.S. Treasury Secretary Henry M. “Hank” Paulson Jr., TARP was re-cast to involve direct capital injections into banks. If the bank’s desired leverage is 12 to 1, then $10 billion of new capital allows it to support an additional $120 billion of assets, reducing its leverage problem far more than would $10 billion of asset sales. With Britain and other countries making similar capital injections, the LIBOR market has this week greatly improved. The interbank market liquidity problem has not gone away altogether, but has been rendered much less serious.

Over the next few months, there is likely to be more differentiation in the market. At one end of the continuum will sit a majority of good banks, for which the government’s capital has removed all danger, meaning these institutions will try to expand their lending business in a market where lending is much more profitable. Their new profits may not help shareholders much initially, as losses still will be caused by old problems being written off. But in the long run, these banks will provide very attractive returns for shareholders – paying off their government capital once market conditions have eased fully.

At the other end of the continuum will sit a small group of banks that face a very disheartening reality: The old problems on their balance sheets are larger than the total amount of the new capital they have received and the money they can earn from new lending. As the market discovers these banks’ more severe problems, the LIBOR rates for different banks will diverge, as they did in 1974. The bad banks will find it more expensive to attract funding, their profitability will decline further and they will become uncompetitive on the best new lending opportunities. Eventually, they will be forced out of the market, either through bankruptcy or some other process that culls the weak players from the strong.

For the rest of us, we can rejoice that the government’s capital injections have solved the problems of most banks, and look forward to lending conditions finally easing a bit in the months to come. That hopefully will prevent the U.S. and global economies from sliding into Great Depression II.

It also should create some very good values in stocks. But maybe we should look at industrials – that carry very little debt – as opposed to banks, at least until the market has sorted out precisely which banks will survive long-term.

Source: How LIBOR Threatened to Destroy the Global Banking System