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LIBOR OIS Spread Signals Credit Crisis Earthquake

Interest-Rates / Credit Crisis 2008 Oct 07, 2008 - 06:29 AM

By: Money_Morning

Keith Fitz-Gerald writes: More than a year ago, even before the subprime-mortgage crisis had revved itself up into the full-fledged credit crisis that's now threatening global growth, we pointed to the London Interbank Offered Rate (LIBOR) and other interbank rates that suggested that the worst was yet to come.

The Money Morning team has continued to watch this important risk indicator, and has regularly reported our findings to you. Each time, we've preached caution, even though the pundits were telling the masses that the bailout plan was a panacea for what's actually a financial mess whose fallout continues to spread.

So what is LIBOR telling us now?

Unfortunately, the worst is still yet to come. That's it. No sugar coating. No rose-colored glasses.

Yesterday (Monday), the spread between Overnight Indexed Swaps (OIS) and the three-month LIBOR rose to an all time high of 2.94%. The LIBOR/OIS spread measures the amount of cash available for interbank lending and is used by banks to determine interest rates. The wider the spread, the less cash there is to go around. This is telling us that banks, despite billions of central-bank support in recent months, are still cash-strapped and are disinclined to lend money either to each other or to consumers.

Then there's LIBOR itself, the rate that banks charge each other for overnight dollar loans, which rose to 2.37% yesterday, the British Bankers' Association said. The three-month LIBOR rate has retreated only slightly from a nine-month high of 4.33%, set last January.

LIBOR actually is a set of rates, and is calculated for several currencies based on periods ranging from overnight to 12 months. That, in turn, determines prices for financial contracts valued at $393 trillion as of Dec. 31, or $60,000 for every person in the world, and helps set consumer interest rates on everything from home loans to credit cards, Bloomberg News reported. The BBA compiles the dollar rate every day from data submitted by 16 banks, including Deutsche Bank AG ( DB ) and Royal Bank of Scotland Group PLC (ADR: RBS ). There are also rates for the euro, Japanese yen, British pound, Swiss franc, and Australian and Canadian dollars.

During the past week, as U.S. lawmakers tussled over a bailout plan and governments in Europe were forced to intercede to rescue five banks , the cost of one-month bank loans in euros and overnight dollar loans soared to records. That basically means banks are hoarding cash, a reality that raises borrowing costs and causes economies worldwide to slow.  Yesterday's three-month LIBOR for loans in dollars jumped to 4.33%, Bloomberg reported.
Meanwhile the so-called TED spread or the difference between three-month LIBOR and what the U.S. Treasury pays for a three-month loan hit an all-time high of 3.93%, before pulling back slightly. The TED spread provides a gauge of how likely banks are to lend to each other, rather than to the Federal Government.

Under normal conditions, the banks charge each other premiums that are historically not much higher than government Treasuries. The fact that the spread is at all-time highs seemingly confirms that banks don't want anything to do with one another, and would rather deal with the government.

Here's what to do now:

1. Make sure you have your cash tucked away in ultra safe T-bills or funds that invest exclusively in short-term Treasury securities.
2. Make sure you own at least one of the specialized inverse investments we've recommended throughout this crisis. That way you can turn what will be a monster loss for most into major profit opportunities.
3. Make sure you combine downside hedges in your portfolio with choices that don't dismantle your upside potential. This includes hard assets and other inflationary hedges, as well as plain-old-fashioned balanced funds and even income-oriented investments.

News and Related Story Links:

• Money Morning News Analysis : Euro Debt Market Faces ‘Pivotal' Test With $140 Billion Maturing .
• Wikipedia : Overnight Indexed Swaps .
• Bloomberg News : Libor Mystifies Americans as Mayor Reads `Doomsday.'
• Wikipedia : Yield Spread .
• Money Morning News : Banking Bailout Becomes Law With House Vote, Bush Signing .
• Money Morning News : Credit Crisis Update: Foreign Stocks Dive Monday on Trio of European Bank Bailouts .
• Wikipedia : TED Spread .

Keith Fitz-Gerald
Investment Director

Money Morning/The Money Map Report

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