LONDON, Aug 12 (IFR) - Options are rapidly running out for Europe's ailing mid-tier banks as nervous creditors pull the plug on once vital sources of funding in response to growing sovereign contagion worries, sowing the seeds of an imminent liquidity crisis at the heart of the eurozone.

With bond markets shut and investors unwilling to buy asset-backed securities, the repo market - for some banks the sole remaining source of private funding - has become the most recent tap to run dry, with some investment banks pulling credit lines worth tens of billions of euros in recent weeks.

Bankers who once ran the now-defunct repo facilities for mid-sized European banks say the credit lines were withdrawn after risk managers became concerned about their own exposure to the enfolding sovereign debt crisis, leaving some clients now solely reliant on central banks for cash.

Given what's going on in the markets, there are big question marks surrounding some of these clients, said one banker who has closed such lines. The appetite from investment banks is fading. There is a great deal of concern about financing wrong-way collateral.

Many of the wholesale banks are starting to rethink these credit lines, added the global markets chief of one European investment bank heavily present in the repo markets. Things can turn pretty nasty if you get these things wrong.

The funding drought is all the more dramatic given that it's only a few weeks since most European lenders were comfortably able to raise funds in markets. Covered bond issuance has been particularly popular, with Italian banks selling 11.9 billion euros of the securities so far this year and Spanish banks 18.2 billion euros.

MARKETS CLOSED

But there has not been a single publicly announced European covered bond deal since June, and other parts of the bond markets also remain closed to most. That could create a strain on banks' finances, which need to raise cash to pay maturing debts. According to the European Banking Authority, the region's banks have 4.8 trillion euros of wholesale and interbank funding expiring this year and next.

The closure of traditional credit lines is a clear sign that concern over European sovereign debt has infected the region's banks. Many in the region are big holders of their respective government's debt. According to the EBA stress tests published in July, the 90 banks it surveyed held a total of 326 billion euros in Italian government debt, 287 billion euros of Spanish public debt, and 215 billion euros of French.

Everyone has been cutting off their exposure, said the head of another European investment bank. It started with Greece, then Spain and now Italy. People don't want to do business with these banks. Many of them have good underlying businesses but they are stuffed.

Before recent developments, repo markets were steadily gaining importance for banks. The facilities, financial market equivalents of pawn shops which allow banks to borrow against collateral for specific time periods, helped many firms generate cash out of assets sitting on banks' balance sheets.

TRI-PARTY REPO UPTICK

While large parts of the repo markets lend against safer collateral such as government bonds and other investment grade securities, there had been a growing tendency by some investment banks to accept riskier assets, which clients had been pushing to use after running out of higher-grade assets.

To begin with it was good collateral, things like good corporate bonds and securitized loans, said the first banker. But then some clients began to run out of that collateral. The bank would force substantial haircuts and punitive interest rates on lesser collateral to protect themselves, he added.

The latest repo markets survey by the International Capital Market Association indeed shows a marked pick-up in the use of riskier assets in European tri-party repo deals. Though small as a proportion of the region's entire 5.91 trillion euro repo market, the use of assets with a rating of below BBB- accounted for 5.1 percent of all transactions in December, up from 1.2 percent a year earlier.

That has now largely stopped, say bankers once heavily involved in such deals. Previously, they were able to hedge their exposures to such collateral - or repackage the collateral on behalf of clients to sell off in chunks to fund managers. But growing investor concern, and a rush toward safer assets, has meant that neither investment banks nor investors want to go near the stuff.

We've attempted to do some trades with illiquid assets on behalf of peripheral banks, but we haven't managed to syndicate deals, said one senior banker that helped repackage some past deals. Anything slightly peripheral-orientated is completely out of the question right now.

FINANCIAL DETRITUS

For many, the European Central Bank is now the last remaining source of liquidity. Under its open market operations - brought in during the depths of the crisis to pump liquidity into the region's banks - its member central banks provide unlimited repo financing against certain eligible assets.

Demand for that money has been picking up of late, as banks feel the squeeze of dry private credit lines. Earlier this week, the Italian central bank said lenders asked for 80.5 billion euros of liquidity during July, almost double what it provided only a month earlier in a sign of banks' deteriorating finances.

Total use of the ECB's main refinancing and long-term refinancing facilities - both part of the open market operations - are now close to 500 billion euros, up from about 400 billion euros in the spring.

According to Goldman Sachs, although such levels are well short of the almost 900 billion euros used in 2009, the uptick is worrying. This is a substantial figure, reflective of the strains in the banking system, analysts wrote.

But banks' use of the ECB open markets operations remains dependent upon them having ample quality assets on their books. Under the terms of the operations, the central bank will only provide liquidity against certain assets - generally those rated BBB- and above, with some exceptions.

If ECB eligible collateral runs out, banks will have little option but to sell off assets in a final fire sale, say bankers. That will depend on whether there are willing buyers for such assets, much of which were accumulated pre-2007 as retail, commercial and wholesale loans.

The financial wreckage at many of these banks is along the lines of World War Two, added the global markets chief. There is so much detritus. But a lot of them don't want to sell at these current prices, they know there will be a capital hit if things are properly priced.

(Additional reporting from Chris Whittall, Aimee Donnellan and Matthew Attwood in London)