Odds rising of a money market driven blowup: James Saft

By James Saft

LONDON (Reuters) - For every day the world's money markets remain dysfunctional, the chances of the very kind of financial failure they fear rises.

A rolling credit crunch emanating from U.S. subprime lending has spread through the asset backed commercial paper market through to interbank money markets, the very heart of the global financial system.

And while central banks have regained a semblance of control, more or less, over the overnight lending markets, there is still a hugely unusual unwillingness by financial institutions to lend each other money for three months.

There is debate about why this is happening, but what is clear is that there are people out there with a huge mismatch between how long their commitments to lend money are compared to the length of time for which they are able to borrow.

That leaves these financial entities, be they conduits or mortgage lenders or whoever else, extremely vulnerable in a market which is already highly agitated.

This knowledge must, in turn, make the money markets still less willing to extend credit for longer periods.

INDIGESTION OR SUSPICIAN?

So, how did we come to be here, and who is responsible for getting things back on track? It's easier to answer the first question than the second.

The problems with U.S. mortgages and structured finance has shaken the faith of the world's lenders in the value of collateral and the credit ratings upon which the whole edifice has been built.

The asset backed commercial paper market, where many of the people who made such mortgage loans found financing, has partially shut, with many unable to get funding and many now only able to get it for a week at a time, where previously they might have obtained 30 or 60 day loans.

These markets have shrunk by about quarter of a trillion dollars in a month in the U.S. alone, and much of the money has found its way on to banks' balance sheets, either because the banks had extended a commercial paper backup line to someone which has now been drawn, or because they have chosen to bail out a conduit or other entity with which they had a relationship.

At the same time, the banks look like getting stuck with something like another $300 billion of bridge bank loans extended to private equity and other acquirers under very aggressive terms. These loans may now be difficult or impossible to sell.

Tim Bond, head of global asset allocation at Barclays Capital, estimates that the asset backed commercial paper market together with bridge loans represents 9 percent of banks' assets. If the CP turn into loans and the bridge loans turn into assets this could cause capital adequacy issues in the absence of new sales of bank bonds or equity.

Banks are selling debt, but it is not an overnight process and not easy for all to do at the same time at an acceptable price.

"The problem in the market is one of quantity and volume of assets coming on to bank balance sheets, and a deficiency of term liquidity to fund those," said Bond, speaking before the Bank of England and ECB left rates unchanged on Thursday.