Coins DIG

Last fall, markets froze and interest rates soared as investors dumped stocks and corporate bonds and banks cut back on lending to their customers and to each other. In response, the Federal Reserve sharply cut interest rates and established a Scrabble game's worth of acronymic lending and insurance programs to reassure investors and jump-start markets.

Those programs have helped return markets to near normal. Lending has resumed, and many key rates are back to where they were before the peak of the crisis. But in cases where the government has pulled back its support, markets have trembled. Given that history, officials will likely err on the side of intervening too much and for too long.

"When the recovery is self-reinforcing and cash flow is picking up for companies and banks, then financial assets will grow on their own without any need for government involvement," says Tony Crescenzi, chief bond strategist at Miller Tabak. "We are nowhere near that self-reinforcing state."

In one sign of lingering credit-market anxiety, interest rates not under direct Fed control -- corporate bonds, for example -- haven't fallen as sharply as overnight lending rates, over which the Fed has the greatest power.

"Where there's been the most intervention, there has been the largest decline relative to previous trends" in interest rates, notes Citigroup economist Steven Wieting. "It makes the case that policy is heavily influencing markets, directly and indirectly."

One of the key markets to seize up last fall was for asset-backed commercial paper, which is generally held by money-market funds and is backed by assets such as auto loans or mortgages. Money-market funds, fearful they couldn't sell these securities to meet redemptions, stopped buying them. So the Fed launched its Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF for short), saying it would buy up all of the asset-backed commercial paper that any fund wanted to sell.

The AMLF had seen very little action, a sign that the market could function on its own. But when the Fed announced two weeks ago that it wouldn't accept commercial paper that had been placed on "negative watch" by credit-rating agencies, funds borrowed heavily against the AMLF, to the tune of at least $30 billion, notes Barclays Capital money-market strategist Joseph Abate. This suggested money funds were worried about getting stuck with paper they couldn't sell, a sign that the market still needed the government backstop to function normally.

"If there was a full, broad and deep recovery in financial markets, we wouldn't have seen this," says Mr. Abate. "Funds would have said, 'So what if they're tightening standards, there's enough liquidity that I don't have to worry.' "

Another situation involves debt issued by banks. The U.S. government's Federal Deposit Insurance Corp. has been guaranteeing bank debt since the crisis peaked, allowing banks to borrow just above low government rates. Morgan Stanley paid one percentage point above Treasurys when it sold FDIC-backed debt in January, similar to what it paid before the crisis, in 2006. But last week when it announced plans to sell $4 billion in senior notes not backed by the government, it had to pay four percentage points over Treasurys.

Even healthier banks are paying interest rates far higher than in the past. Bank of New York Mellon, which wasn't ordered to raise capital under the government stress tests, recently issued non-FDIC-backed debt yielding 2.25 percentage points above Treasurys. A similar note issued in 2006 yielded 0.55 percentage points over Treasurys.

In some cases, one government program, such as a Fed program to buy commercial paper directly from companies, hasn't had much action because banks have found it cheaper to sell debt backed by the FDIC, says Mr. Crescenzi of Miller Tabak.

And while a plan by the Fed and other central banks to provide dollars to non-U.S. banks worked well, helping to drive down the London interbank offered rate, banks in need of dollars are pulling them out of their U.S. branches rather than go to central banks. The problem that led to this program -- that banks wouldn't lend to each other -- hasn't been completely solved.

Markets not directly affected by government help, such as stocks and corporate bonds, have soared recently, though only to levels seen at the end of last year. Stocks remain 40% off their all-time highs and BBB-rated corporate bonds trade at a spread of about six percentage points above comparable Treasurys, compared with one percentage point before the crisis. With the government guaranteeing vast portions of the financial markets, it is difficult to determine how these markets would have performed otherwise.

"Insurance changes behavior," says Howard Simons, a bond strategist at Bianco Research in Chicago. "If you take the insurance away, you change the behavior."

Source: online.wsj.com