Banks get scary again

    Market-based anxiety measures have crept steadily higher over the past month, reflecting a marked shift in investor psychology. Less than two years after governments made promises totaling trillions of dollars to prop up the financial system, fears that Europe's banks will fall ill are pummeling the markets again.

    Libor, the rate at which highly rated banks borrow from one another on an unsecured basis, has more than doubled since February to 0.54%, its highest level since last summer. The rise shows that bankers are worried about getting repaid at a time when banks everywhere are still relying on government support, and state finances in Europe and elsewhere are looking increasingly shaky.

    "Who are you willing to lend to when things are changing so rapidly?" said David Merkel, chief economist at broker-dealer Finacorp Securities. "A lot of lines are getting cut right now."

    Shares in the biggest European banks are down 20% or more from their level at the beginning of 2010, and big American financial firms are giving back the gains they made in a trading-fueled first-quarter profit feast.

    Spain's Santander (STD), for instance, dropped 5% Tuesday and is down 40% for the year. Deutsche Bank (DB) of Germany slid 3% and is down 21% for 2010.

    Bank of America (BAC), which traded near $20 after its first-quarter earnings release in April, traded below $15 Tuesday morning, putting it down 1% for the year. Citi (C), which posted a modest gain yesterday as other banks sold off, gave back its gains Tuesday.

    The problem starts with the banks, which made bad loans during the credit bubble of the past decade and then were propped up thanks to government support. Now that investors are wondering if the government debt will be paid off in full, the banks and those who lend to them are struggling to figure out what their holdings are really worth.

    Observers warn that the uncertainty could lead to a lending pullback similar to the one that sent the United States tumbling into recession at the end of 2007, if perhaps not of the same scope.

    "As the market value of, say, Spanish government debt declines, banks which hold that debt can't borrow as much against it and therefore can't lend as much to their end customers," says Guy LeBas, a credit strategist at Janney Montgomery Scott in Philadelphia.

    As worrisome as the rise in Libor and other measures are, LeBas said there is little sign yet that the problem will get out of control.

    He noted that Libor spiked to nearly 10 times its current level following Lehman Brothers' collapse in the fall of 2008. What's more, the recent move has been slow and steady, a basis point (one-hundredth of a percentage point) or two at a time.

    LeBas said a look back at Libor over time shows that liquidity crises inevitably follow a 10-basis-point move overnight. There were plenty of those in the fall of 2008 but there has been nothing approaching that magnitude in the past month.

    What's more, Libor remains below its year-ago level of 0.66%, or 66 basis points. In part, that's because central governments have been providing ample cash, muting any panic.

    "Liquidity has been flush, flush, flush," said Merkel.

    But the past month shows policymakers have limited tools to deal with worries about whether banks will repay their borrowings, at a time when it is slowly sinking in that resources are limited and there is no investment that's totally safe.

    Analysts at Citigroup say they believe Libor could reach 1-1.5% in coming months as the market comes to grips with the shape of financial regulation and the price to be paid by creditors who lent to troubled European governments and their banks. That will mean more stress and more fear, and perhaps lower prices for bonds and stocks.

    But so far, no panic.

    "To this point it has been pretty orderly," said LeBas. "But there is no good way for this to affect U.S. markets."