Traditionally, at this time of the year, bankers in Europe and the US are busy attending Christmas cocktail parties, winding down their market exposures, and looking forward to year-end bonuses.

While surely all this is going on, times are not very cheerful for central bankers in particular. The problems in the subprime market which surfaced in August have continued to make headline news more than four months later; more importantly, the crisis has escalated into a credit squeeze with banks unwilling to lend to each other except at a high price.

One measure of the lack of confidence is the spread between dollar treasury bills and the three-month LIBOR. (In many ways, the three-month USD LIBOR is the most important single commercial interest rate in global finance: not only for loans, it is also the most popular benchmark for dollar interest rate swaps which, incidentally, is the most traded derivative in the market.) 

It had been of the order of about 0.5 per cent in mid-year, that is, before the present problems surfaced; it has lately been ruling at almost 200 basis points!

A corollary of this much-wider spread between risk-free and interbank interest rates, which has also been experienced in the EUR, GBP, CAD and CHF markets, is that the cuts in interest rates engineered by the central banks are not getting transmitted to the real economy.

In recent months, the Fed has cut the targeted Fed Funds rate from 5.25 per cent in mid-year to 4.25 now; on the other hand, over this period, the three-month LIBOR had moved by just 0.4 per cent.

Concern about this situation is probably more acute in the euro-zone than elsewhere. The strong euro will start affecting growth sooner rather than later: the French, as usual, are the most worried. No wonder the UK Prime Minister has invited the heads of France and Germany for a summit meeting to discuss the problems in the mortgage and credit markets. No wonder also that the European Central Bank has been the most aggressive intervener in the money market.

In fact, five major central banks (US, Canada, UK, Eurozone and Switzerland) have taken co-ordinated action in the money markets in order to bring the interbank rates at the short end nearer the risk-free rates. While coordinated action and intervention in exchange markets have occurred several times, I am unable to recall a parallel to the recent joint effort to pump money in the banking system. The measures include the following:

• The US Federal Reserve is making available large swap facilities to central banks in Europe in order to ease the shortage of dollars, the currency in which many of the mortgage-backed assets held by European banks, are denominated.
• The central banks are offering large funding to the respective banking systems, and that too against a wider range of collateral and for longer periods. Last Tuesday, for example, the European Central Bank pumped in as much as �350 bn at a fixed rate and succeeded in driving the LIBOR down by more than 0.5 per cent.  Much of the money was for 14 days, maturing after the year end.
• In an unrelated more, the Federal Reserve has proposed new rules to curb malpractices and mis-selling in the mortgage market.

While central banks in Europe are offering dollar funding to European banks, one suspects that the supply is not sufficient to compensate for the rapid shrinkage of the asset-backed commercial paper (ABCP) market.

As may be recalled, a number of special investment vehicles (SIVs), sponsored by European banks, were financing investments in long-term US mortgage-backed securities by issuing commercial paper. The carry was very attractive.

But, in the recent and on-going credit squeeze, the size of the ABCP market has shrunk from $1,200 bn to nearly half. Several of the sponsoring banks have had to take back the assets on their books, with little roll over of the CPs.

But, given the amounts involved, one wonders whether European banks are swapping European currencies in USD to fund the assets: is this the reason why the dollar has risen sharply over the last few weeks? This apart, as far as the SIVs sponsored by American banks are concerned, the big three of US banking - Citi, BankAm and Morgan - had announced the creation of a $75 bn fund to take over assets from the SIVs unable to roll over funding in the CP market.
Given the conditions attached, the fund does not seem to be finding too many takers. The central and commercial banks are by no means the only concerned parties; the politicians are also getting in the act. If Gordon Brown is hosting a summit, George Bush has announced a freeze of interest rates on adjustable rate mortgages due to be re-priced over the next two-and-a-half years. It's expected to benefit a quarter million borrowers.