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Dollar Libor Jumps to New Credit Crisis Extreme

Interest-Rates / Credit Crisis 2008 Oct 09, 2008 - 02:39 PM GMT

By: Mike_Shedlock

Interest-Rates

Best Financial Markets Analysis ArticleLending remains in a deep freeze as the Libor Dollar Rate Jumps to Highest in Year .

The cost of borrowing in dollars for three months in London soared to the highest level this year as coordinated interest-rate reductions worldwide failed to revive lending among banks for any longer than a day.


Attempts by policy makers to restore confidence to money markets are being stymied by almost daily crises among financial institutions. Iceland's government took over the nation's biggest lender today to keep the country's banking system working. American International Group Inc., the insurer taken over by the U.S. government, may need $37.8 billion of extra funds, the Federal Reserve Bank of New York said yesterday.

"To see little or no reaction in the fixings is very disappointing and reinforces the fact that Libor is broken and the transmission mechanism from central banks isn't working," said Barry Moran, a currency trader in Dublin at Bank of Ireland, the country's second-biggest bank. "Things are still very stressed and we don't know what's going to fix it."

The London interbank offered rate, or Libor, for three-month loans rose to 4.75 percent today, the highest level since Dec. 28. The Libor-OIS spread, a measure of cash scarcity, widened to a record. The overnight rate fell to 5.09 percent, still 359 basis points more than the Fed's 1.5 percent target rate.

Money-market rates rose today in Hong Kong, Singapore and Japan to the highest levels in at least nine months. Hong Kong's three-month interbank offered rate jumped to 4.4 percent, a one- year high. Singapore's comparable rate for dollar loans increased to 4.51 percent, the highest level since Jan. 8.

The Libor-OIS spread, the difference between the three-month dollar Libor and the overnight indexed swap rate, climbed 23 basis points to an all-time high of 348 basis points. The average was 8 basis points in the 12 months to July 31, 2007, before the credit squeeze began. The difference between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, exceeded 400 basis points for a second day. TED Spread




Ted Spread Chart courtesy of Bloomberg

The TED spread is the difference in yields between inter-bank and U.S. Government loans.
Initially, the TED spread was the difference between the interest rate for the three month U.S. Treasuries contract and three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.

The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments.

ECB Steps Up 'Fight'

In another counterproductive effort, ECB Steps Up 'Fight' Offers Banks Unlimited Cash

The European Central Bank brought forward plans to lend banks unlimited cash and pumped a record $100 billion in overnight funds into the financial system after an interest-rate cut failed to soothe tensions in money markets.

The "ECB looks keen to take up the fight," said Christoph Rieger, a fixed-income strategist at Dresdner Kleinwort in Frankfurt. "After cutting borrowing costs, the last thing central banks want is for market rates to remain steady or, even worse, rise further."

Commercial banks are refusing to lend to each other after the U.S. housing slump caused the collapse of New York-based Lehman Brothers Holdings Inc. That's pushed market interest rates to records even as the ECB and other central banks injected billions of euros and dollars into the banking system.

Why Should Banks Lend To Each Other?

I think the Fed and the Treasury need to ask a very simple question: "Why Should Banks Lend To Each Other?" Let's tackle this in reverse and look at why they shouldn't.

Why Banks Aren't Lending

  • Banks are insolvent.
  • Banks do not trust each other.
  • There can be no trust with suspended mark to market accounting. No one believes what assets on balance sheets are really worth and there is no way to find out.
  • By suspending mark to market accounting the SEC heightened mistrust.
  • As part of the TARP passed by Congress, the Fed is paying interest on reserves.


Let's look a little bit closer at that last point.

Fed To Pay Interest On Deposits; Considers Unsecured Funding

The $700+ Billion Bailout Bill contained a provision that allows the Fed to start paying member banks on required reserves and excess balances. Here is the Fed press release on deposits .

The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions' required and excess reserve balances.

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector.

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate.

Bottom Fell Out Of The Floor On Rates

Bernanke wanted ability to pay interest on reserves to put in a floor on interest rates. I am quite certain he believed he could hold rates at 2 with this provision. It did not work that way did it? The Fed Fund rates is now at 1.50 and interest rates futures suggest it is headed to 1.00 by March.

But an easily seen (yet still unseen by the Fed) ramification of paying interest on reserves is the fact that banks can collect interest by leaving money on deposit at the Fed rather than lending it out.

Why should banks risk lending money to consumers or bank when instead they can deposit money at the Fed and collect interest? Thus, paying interest on reserves not only failed to put in a floor on rates, it also gave banks one huge reason not to lend.

This cancerous activity is now starting to get extremely counterproductive.

Ownership Of Banks

Undaunted, and willing to force the issue Paulson is floating the idea for the Treasury To Take Ownership Stake In Banks .

I have news for Paulson. Taking a stake in banks won't force lending unless that stake is 51% or greater, with some clown at the Treasury put in charge of running the banks.

Here is a paragraph from the above link that is worth repeating.

The cancerous disease is fractional reserve lending, the very existence of the Fed, and an unsound monetary system. The only cure is to eliminate the Fed, abolish fractional reserve lending, and put in place a sound monetary system backed by gold.

Instead of attacking the cancer (the Fed itself), Bernanke is Pushing on a String In Academic Wonderland .

The problem is not a failure to lend, the main problem is there simply is no pool of real savings to lend. Furthermore, given rampant overcapacity and rising unemployment, there is no reason to lend even if the funding was available.

Robbing taxpayers to the tune of $700 billion does not change the equation.

With that backdrop it's no wonder Bernanke's attempts to free up the credit markets are having the effect of pushing on a string. Should the Fed actually stimulate lending, more money will end up in money heaven as a consequence.

Academic Wonderland

The credit markets are choking on credit, yet Bernanke is attempting to force more credit down everyone's throats. Logic dictates the solution cannot be the same as the problem.

Trapped in academic wonderland, such simple logic is far too complex for Bernanke to understand. Sadly, we are all forced to watch Bernanke flop about like a fish out of water attempting to solve a solvency problem with ridiculous liquidity schemes like the TAF, PDCF, TSLF, TARP, and the ABCPMMMFLF.

By Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

Click Here To Scroll Thru My Recent Post List

Mike Shedlock / Mish is a registered investment advisor representative for SitkaPacific Capital Management . Sitka Pacific is an asset management firm whose goal is strong performance and low volatility, regardless of market direction.

Visit Sitka Pacific's Account Management Page to learn more about wealth management and capital preservation strategies of Sitka Pacific.

I do weekly podcasts every Thursday on HoweStreet and a brief 7 minute segment on Saturday on CKNW AM 980 in Vancouver.

When not writing about stocks or the economy I spends a great deal of time on photography and in the garden. I have over 80 magazine and book cover credits. Some of my Wisconsin and gardening images can be seen at MichaelShedlock.com .

© 2008 Mike Shedlock, All Rights Reserved

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