NEW YORK (Reuters) – Banks borrowed a record amount of funds from the Federal Reserve in the latest week as the year old credit crisis took a persistent toll, while the commercial paper market continued to contract, signaling tough conditions for short term borrowers.

Banksprimary credit borrowings averaged $17.45 billion per day in the
latest week, the second straight week this had hit a record and up from
$16.38 billion the previous week, Fed data showed on Thursday.

"It shows theres a shortage of liquidity in the system," said Christopher Low, chief economist at FTN Financial in New York.

Secondary credit the Fed extended, which is usually taken out by banks
in need of emergency cash, rose to $89 million in the latest week, from
$34 million the week before. Although these numbers are still very
small compared with primary credit, "What that tells you is that
theres an increasing number of banks that the Fed is classifying as
‘unsoundor inadequately capitalized," Low said.

Analysts may watch the trend of secondary credit closely, given the
travails of U.S. regional and smaller banks and the likelihood that a
continued decline in house prices and rise in foreclosures and bad
loans will deepen the difficulties of the banking sector for many
months or years.

Some analysts ascribed the overall rise in demand to use the Feds
short term discount window borrowing facilities to a mix of factors.

"I am sure there are troubled banks trying to tap the window," said
Michael Feroli, U.S. economist with JPMorgan in New York. But he added:
"more and more banks are trying to take advantage of the pure economic
advantage of borrowing at a cheap rate and you are seeing a gradual
fading away of the stigma of using the discount window."

The Feds main discount rate is 2.25 percent.

Meanwhile, the U.S. commercial paper market, a vital source of
short-term funding for daily operations at many companies, fell $16.0
billion to $1.728 trillion, the lowest level outstanding in two years,
from $1.744 trillion the previous week, Federal Reserve data showed on
Thursday.

"The panic of last year is over. Its more orderly now, but the
financial stresses remain and there will be more difficulties to come,"
said John Canavan, market analyst at research company Stone &
McCarthy in Princeton, New Jersey.

Part of the overall decline was attributable to asset-backed commercial
paper, a subsector that has been eroded by the slide of housing and
mortgage-related securities.

U.S. asset-backed commercial paper outstanding fell by $6.1 billion
after rising $4.7 billion the previous week. U.S. asset-backed
commercial paper outstanding declined to a total $743.9 billion in the
latest week from $750.0 billion the previous week.

"The asset-backed outstanding continues to creep a little lower,"
Canavan said. "No one is willing to touch the asset-backed commercial
paper because people are concerned about the intrinsic value of the
underlying issues, mortgage-related securities."

Foreign central banks, who own over a quarter of marketable Treasuries,
were net buyers of U.S. government bonds in the latest week, but were
net sellers of agency securities, Federal Reserve data showed on
Thursday.

Foreign institutions sold securities from government-sponsored agencies
like Fannie Mae (NYSE:FNM – News) and Freddie Mac (NYSE:FRE – News),
subtracting $2.39 billion from those holdings, which now stand at
$981.69 billion.

The breakdown showed overseas central banks bought $17.89 billion in Treasury debt, bringing the total to $1.395 trillion.

The interbank cost of borrowing three-month dollar funds posted its
biggest fall in a month on Thursday, according to the British Bankers’
Association, a day after central banks announced more liquidity
boosting measures.

The London 3-month dollar-denominated interbank offered rate was fixed
at 2.79125 percent (USD3MFSR=) versus 2.80063 percent the previous
session.

U.S. primary dealers borrowed a modest $3 million from the U.S. central
banks Primary Dealer Credit Facility in the latest week, versus an
average of zero per day the week before.

Dealers took $28.1 billion in Treasuries of the $50 billion the Federal
Reserve offered at its weekly Term Securities Lending Facility auction
on Thursday, not covering the total amount on offer, but still a sign
of hefty demand.

Cash strapped financial institutions can convert the Treasuries
temporarily into short term cash loans in the repurchase market in
order to shore up balance sheets depleted by the credit crisis.