Weak Players Finding Fed Funds Scarce
Shouting voices and ringing telephones fill the air on the New York trading floor of Babcock Fulton Prebon, a leading broker of fed funds.
But the constant activity cannot mask a sea change taking place in the federal funds market, where traders handle $180 billion daily - 30 times the volume of the New York Stock Exchange.
Alarmed by declining credit quality, many banks have slashed credit lines to weaker institutions.
Meanwhile, strong foreign banks and some U.S. government agencies have entered the market, sopping up available funds.
The consequence is a Darwinian struggle in the giant fed funds market. When the turmoil settles, only the strongest banks will have survived with their sources of liquidity intact.
"In the old days, a New York bank could buy $1 billion in two or three takes," said one fed funds trader. "Now, for weaker money-centers it could take 25 to 30 trades - and the market's got to be extremely liquid." (Although traders routinely talk about buying and selling fed funds, the transactions actually involve uncollateralized loans.)
Big New York banks have had to endure substantial cuts in their credit lines. "Most money-centers have seen their [credit] lines dwindle 10% to 40% over the past year," said a fed funds trader at a large New York bank.
Down by $2 Billion
One money-center banker said his bank has lost over $2 billion in credit lines from Federal Home Loan banks in the past two years.
Further north, a number of large New England banks are able to buy only about 25% of what they could a year ago, according to a fed funds trader there. Moreover, he said the situation is getting worse: "It has accelerated recently to the degree that problems in the banking system have accelerated."
If word gets out that a bank is having to search for a source of fed funds, that alone can create problems.
Other banks may take the search as a sign the bank is having liquidity problems. In response, they may cut credit lines, which in itself deepens a vicious cycle of declining liquidity.
"If you get downgraded, you become a pariah," said a fed funds broker. "No one wants to sell to you, and it exacerbates the problem."
A silent telephone is often the first sign that a fed funds credit line is in jeopardy. Then the fed funds trader starts calling other banks, only to confirm initial apprehensions.
Other traders may say outright that credit lines are no longer available, or they may equivocate by saying that they have no funds to sell. Either way, the bank that needs fed funds has a knotty problem.
A fed funds trader at one large bank recalled contacting about 20 banks without finding one that was willing to sell. "We literally could not get any money out of the market," the trader said.
The appearance of liquidity is critical for access to the fed funds market. But for a bank to show it has adequate liquidity, it must indicate that it does not need to buy fed funds. In effect, for a bank to be able to buy fed funds it must sell fed funds.
Keeping a Low Profile
"You stay away from the market," said a banker at one such institution, describing the tactics his bank has used. "You go and look for other markets to borrow quietly. You might jack up your retail CD rates, for example. You never let the market know you're there."
Tethered to their desks by telephones, about 20 fed funds brokers at Babcock Fulton Prebon shout constantly to each other, leaping up from chairs and gesturing wildly on news of any market development. Lights blink on and off on their "phone boards" - electronic boards each with 120 direct lines to clients' desks.
Most of the 20-odd traders at Babcock Fulton Prebon have been there for several years, and some have been there nearly a dozen. A few have brought relatives to work with them there.
And the brokers have their own language. "Dino, P---, you want 10 at three-eights?" means Dino, it's P--- Bank, do you have a client who wants to buy $10 million worth of fed funds at 5 3/8%?
"It's a pretty cohesive group, no question," said Lawrence J. DiTore, a senior vice president there.
The entire fed funds market once operated as smoothly as the broker's operation. Banks traded without much fear that uncomfortable or embarrassing situations would develop.
But today's market for fed funds, the funds banks trade among each other to meet central bank reserve requirements, is a challenge to navigate. A growing number of bankers looking for fed funds are hearing through their brokers that "this guy doesn't sell to you any more."
The tensions have their roots in the banking industry's troubles over the past two years.
As banks found themselves with huge, unexpected asset quality problems, the ratings agencies responded, lowering their estimations of scores of U.S. banks.
Many bankers were obliged to follow internal rules limiting how much they could trade with banks accorded low ratings, and others simply decided to cut lines because they were concerned about having large exposures to weak institutions.
Consider the rating changes made by Thomson Bank Watch in the past 18 months. Between January 1990 and July 1991, the rating agency issued 215 downgrades and only 35 upgrades. Thomson BankWatch is an affiliate of the American Banker.
Bankers depend heavily on Thomson's ratings, which run from A (best) to E (worst), when they determine the size of the credit lines they will extend to other banks.
But today, J.P. Morgan & Co. and Wachovia Corp. are the only large U.S. banks rated A, Thomson's top category. A number of big banks - Chase Manhattan Corp., Chemical Banking Corp., Security Pacific Corp., First Interstate Bancorp, and Bank of New York Corp. - are rated C, a level that leads some other banks to limit credit lines.
Making matters worse, foreign banks are increasingly active in the fed funds market. These institutions, many of which have ratings well above most U.S. banks, are seeing their credit lines grow as fed funds sellers try to keep credit lines limited to strong banks.
Even the Federal Home Loan banks are getting into the act. They are some of the biggest participants in the fed funds market, and in the past two years they have reportedly opened credit lines as large as $1 billion to dozens of highly rated foreign banks.
"They have credit ratings they adhere to, and they're not going to sell to C [-rated] banks. You might as well walk around like a leper with a bell around your neck." one fed funds trader said.
As more foreign banks get larger credit lines in the fed funds market, there are fewer market-rate funds available to domestic banks.
A few years ago, "there was some belief that the American savings and loan industry ought to supply money to U.S. banks and not to foreign banks," said a fed funds trader at a New York bank. "This time around, it's different."
The track record of the Home Loan Bank System's centralized funding operation tells the story. In mid-June, foreign banks had purchased more than half of the funds that operation reported as sold.
The centralized operation has since shut down, and the individual banks are handling all their own needs. But no one expects the change to result in more lines opening to U.S. banks.
Many banks can meet their reserve requirements through their daily operations. The typical regional bank receives more than enough cash to meet its normal reserve requirements from regular deposit inflows. But wholesale banks and money-centers, banks that obtain less of their funding from deposits, are harder pressed to come up with the reserves they need on their own.
Banks that cannot raise the funds they need through normal operations or the interbank market have few options. They can pressure their correspondent banks to supply them with funds, because smaller banks with large deposit bases often have excess reserves.
Or they can offer to pay above-market rates for fed funds, inducing some banks to "overline," or temporarily sell more than they are supposed to. But if those approaches do not work, banks borrow at the discount window of their local Federal Reserve Bank.
The Discount Window
At 5.5%, the discount rate is currently the same as the rate prevailing on fed funds, and it is often pegged lower than the target fed funds rate. In exchange for the low rate, banks must put up collateral to borrow at the fed funds window, and they must also endure closer regulatory scrutiny.
Moreover, if word gets out that a bank is borrowing, the weakness such action suggests often leads to new cuts in its credit lines from other banks. As a result, discount window borrowing is something most banks try to avoid at almost any cost.
Southeast Banking Corp. borrowed from the Federal Reserve Bank of Atlanta recently - but only after its correspondent banks balked at selling fed funds to the deeply troubled Miami bank.
A year earlier, the erstwhile Bank of New England also became all too familiar with the process. That bank reportedly went to the discount window at the Boston Fed to borrow hundreds of millions of dollars in the weeks following its announcement that it would report a fourth quarter 1989 loss of $1.2 billion.
Eventually, the industry will return to health, and banks will feel more comfortable about trading with each other.
PHOTO : $180 BILLION changes hands daily in the fed funds market, centered on trading floors like Babcock Fulton Prebon's in New York.
PHOTO : A TRADER shouts an order at Babcock Fulton Prebon.
PHOTO : TETHERED to their desks by telephones, brokers at Babcock Fulton Prebon shout constantly to each other.