Best of the Week
Most Popular
1. TESLA! Cathy Wood ARK Funds Bubble BURSTS! - 12th May 21
2.Stock Market Entering Early Summer Correction Trend Forecast - 10th May 21
3.GOLD GDX, HUI Stocks - Will Paradise Turn into a Dystopia? - 11th May 21
4.Crypto Bubble Bursts! Nicehash Suspends Coinbase Withdrawals, Bitcoin, Ethereum Bear Market Begins - 16th May 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.Cathy Wood Ark Invest Funds Bubble BURSTS! ARKK, ARKG, Tesla Entering Severe Bear Market - 13th May 21
7.Stock Market - Should You Be In Cash Right Now? - 17th May 21
8.Gold to Benefit from Mounting US Debt Pile - 14th May 21
9.Coronavius Covid-19 in Italy in August 2019! - 13th May 21
10.How to Invest in HIGH RISK Tech Stocks for 2021 and Beyond - Part 2 of 2 - 18th May 21
Last 7 days
Overclockers UK Custom Built PC 1 YEAR Use Review Verdict - Does it Still Work? - 16th Oct 21
Altonville Mine Tours Maze at Alton Towers Scarefest 2021 - 16th Oct 21
How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
The Only way to Crush Inflation (not stocks) - 14th Oct 21
Why "Losses Are the Norm" in the Stock Market - 14th Oct 21
Sub Species Castle Maze at Alton Towers Scarefest 2021 - 14th Oct 21
Which Wallet is Best for Storing NFTs? - 14th Oct 21
Ailing UK Pound Has Global Effects - 14th Oct 21
How to Get 6 Years Life Out of Your Overclocked PC System, Optimum GPU, CPU and MB Performance - 13th Oct 21
The Demand Shock of 2022 - 12th Oct 21
4 Reasons Why NFTs Could Be The Future - 12th Oct 21
Crimex Silver: Murder Most Foul - 12th Oct 21
Bitcoin Rockets In Preparation For Liftoff To $100,000 - 12th Oct 21
INTEL Tech Stock to the MOON! INTC 2000 vs 2021 Market Bubble WARNING - 11th Oct 21
AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
Stock Market Wall of Worry Meets NFPs - 11th Oct 21
Stock Market Intermediate Correction Continues - 11th Oct 21
China / US Stock Markets Divergence - 10th Oct 21
Can US Save Taiwan From China? Taiwan Strait Naval Battle - PLA vs 7th Fleet War Game Simulation - 10th Oct 21
Gold Price Outlook: The Inflation Chasm Between Europe and the US - 10th Oct 21
US Real Estate ETFs React To Rising Housing Market Mortgage Interest Rates - 10th Oct 21
US China War over Taiwan Simulation 2021, Invasion Forecast - Who Will Win? - 9th Oct 21
When Will the Fed Taper? - 9th Oct 21
Dancing with Ghouls and Ghosts at Alton Towers Scarefest 2021 - 9th Oct 21
Stock Market FOMO Going into Crash Season - 8th Oct 21
Scan Computers - Custom Build PC 6 Months Later, Reliability, Issues, Quality of Tech Support Review - 8th Oct 21
Gold and Silver: Your Financial Main Battle Tanks - 8th Oct 21
How to handle the “Twin Crises” Evergrande and Debt Ceiling Threatening Stocks - 8th Oct 21
Why a Peak in US Home Prices May Be Approaching - 8th Oct 21
Alton Towers Scarefest is BACK! Post Pandemic Frights Begin, What it's Like to Enter Scarefest 2021 - 8th Oct 21
AJ Bell vs II Interactive Investor - Which Platform is Best for Buying US FAANG Stocks UK Investing - 7th Oct 21
Gold: Evergrande Investors' Savior - 7th Oct 21
Here's What Really Sets Interest Rates (Not Central Banks) - 7th Oct 21
CISCO 2020 Dot com Bubble Stock vs 2021 Bubble Tech Stocks Warning Analysis - 6th Oct 21
Precious Metals Complex Searching for a Bottom - 6th Oct 21
FB, AMZN, NFLX, GOOG, AAPL and FANG+ '5 Waves' Speaks Volumes - 6th Oct 21
Budgies Flying Ability 10 Weeks After wings Clipped, Flight Feathers Cut Grow Back - 6th Oct 21
Why Silver Price Could Crash by 20%! - 5th Oct 21
Will China's Crackdown Send Bitcoin's Price Tumbling? - 5th Oct 21
Natural Gas News: Europe Lacks Supply, So It Turns to Asia - 5th Oct 21
Stock Market Correction: One More Spark to Light the Fire? - 5th Oct 21
Fractal Design Meshify S2, Best PC Case Review, Build Quality, Airflow etc. - 5th Oct 21
Chasing Value with Five More Biotech Stocks for the Long-run - 4th Oct 21
Gold’s Century - While stocks dominated headlines, gold quietly performed - 4th Oct 21
NASDAQ Stock Market Head-n-Shoulders Warns Of Market Weakness – Critical Topping Pattern - 4th Oct 21
US Dollar on plan, attended by the Gold/Silver ratio - 4th Oct 21
Aptorum Group - APM - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 3rd Oct 21
US Close to Hitting the Debt Ceiling: Gold Doesn’t Care - 3rd Oct 21
Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
Original Oculus VR HeadSet Rift Dev Kit v1 Before Facebook Bought Oculus - 3rd Oct 21
Microsoft Stock Valuation 2021 vs 2000 Bubble - Buy Sell or Hold Invest Analysis - 1st Oct 21
How to profit off the Acquisition spree in Fintech Stocks - 1st Oct 21
�� Halloween 2021 TESCO Shopping Before the Next Big Panic Buying! �� - 1st Oct 2
The Guide to Building a Design Portfolio Online - 1st Oct 21
BioDelivery Sciences International - BDSI - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 30th Sep 21
America’s Revolving-Door Politics Behind the Fall of US-Sino Ties - 30th Sep 21
Dovish to Hawkish Fed: Sounds Bearish for Gold - 30th Sep 21
Stock Market Gauntlet to the Fed - 30th Sep 21
Should you include ESG investments in your portfolio? - 30th Sep 21
Takeda - TAK - High RIsk Biotech Stocks Buy, Sell, Hold Investing Analysis for the Long-run - 29th Sep 21
Stock Market Wishing Away Inflation - 29th Sep 21
Why Workers Are NOT Returning to Work as Lockdown's End - Wage Slaves Rebellion - 29th Sep 21
UK Fuel PANIC! Fighting at the Petrol Pumps! As Lemmings Create a New Crisis - 29th Sep 21
Gold Could See Tapering as Soon as November! - 29th Sep 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

How LIBOR Threatened to Destroy the Global Banking System

Interest-Rates / Credit Crisis 2008 Oct 21, 2008 - 10:34 AM GMT

By: Money_Morning

Interest-Rates

Best Financial Markets Analysis ArticleMartin Hutchinson writes: largest financial crisis since the Great Depression has revolved around an interest rate that many U.S. investors are only now hearing about for the very first time: The London Interbank Offered Rate (LIBOR).

But if you understand that rate, and study the forces that have been influencing it, chances are very good that you can figure out how we can escape the current banking-sector mess without wrecking the entire world economy.


Although not a common term here in the U.S. market (where it nevertheless is a presence, as we'll see), it is common knowledge in Europe, and especially in Great Britain, where LIBOR rates are published daily by the British Bankers' Association (BBA).

The London interbank market grew up in the late 1950s as a market for dollars held in Europe. It was separate from the U.S. money market, if only because it took place in different time zones. The rate at which dollar deposits were offered between top-quality banks based in London (both domestic British banks and the London branches of worldwide banks with their headquarters elsewhere) became standardized as the London Interbank Offered Rate .

When money is readily available and the system is working smoothly , LIBOR is uncontroversial: Except for in a few extreme cases, all banks participating in the London market pay close to the same LIBOR rate, because they are all assumed to be solid credits for short-term interbank deposits.

The first time in which the LIBOR system came under stress was in the credit crunch of 1974. The collapse of Bankhaus I.D. Herstatt in June of that year and Franklin National Bank in October frightened the London banks, and made them worry that other banks could unexpectedly disappear, endangering the Interbank-deposit system.

After that happened, the London banks began to insist on higher rates from banks that were thought to be in danger. At the peak of the illiquidity in late 1974, the Japanese trust banks – actually of fine credit quality but at a disadvantage in that they'd only recently set up shop in the London market – were paying as much as 2% more for their deposits than were their U.S. and British competitors.

That brings me back to the current LIBOR debacle. Late last year, when it became clear that the LIBOR market was seizing up , I wasn't surprised, given all the credit problems in the banking system.  After all, if the market perceived banks as suddenly riskier, you would expect the differential between three-month LIBOR and three-month Treasury bills to widen, as lenders demand higher rates from the newly riskier banks.

However, you would also expect the rate differential between banks to widen as it did in 1974 – you would expect LIBOR for the top quality banks to be well below the rate for the competitors.

Of course, that's not what has happened. Three-month LIBOR is roughly 4% more than the yield on three-month T-bills. But there's much less differentiation between LIBOR for different banks – in general, we're talking about only a quarter percentage point from top to bottom.

What's more, when the U.S. Federal Reserve auctioned $150 billion of three-month money last week at 1.4% – far below LIBOR – it wasn't taken up. If credit risk were the problem, that would make no sense: You could pick up more than 3% per annum by borrowing from the Fed and lending to a bank you trusted.

Clearly, credit risk isn't the problem. Banks aren't worried about a possible default of JPMorgan Chase & Co. ( JPM ); they just don't want to make interbank deposits at all, because they are trying to reduce leverage.

Banks borrowed too much money in relation to their capital during the bubble years, so their leverage (roughly their total assets to tangible stockholders' capital) got too high.

That high leverage makes a bank more profitable in good times, but it increases a bank's risk in a downturn, because each dollar of capital has to support the losses on $15, $20 or even $30 of assets. Since last fall, banks have suffered losses on holdings of low-quality debt, which has reduced their capital. At the same time, they have been forced to take back onto their balance sheets assets that they had thought were safely parked in “ Structured Investment Vehicles ,” or SIVs, that were funded with commercial paper – and now the asset-backed commercial paper market has cratered .

Now, banks' best corporate customers are coming to them for commercial loans, because the commercial paper market in general has run into trouble – more assets banks really don't want.

With their assets being forced up and their capital down, banks must reduce their leverage fast, either by reducing assets or by increasing capital – or, ideally, both. Otherwise, the market will view banks as being too risky – a distortion that will boost their borrowing costs and decimate their profits.

One way to reduce leverage is to avoid participation in the interbank market, which is a low-margin business that increases assets without doing much for income. At the same time, even cheap short-term liabilities aren't that attractive; long-term debt (to improve their liquidity position) and proper capital is what banks need.

As I've noted before, the $700 billion Troubled Assets Relief Program (TARP) passed by Congress addressed the wrong problem. By buying $700 billion of banks' lowest-quality assets, the TARP would reduce those institution's assets by only the same $700 billion. It might even damage their capital position, if the banks were forced to write down the assets further and to then sell them to the TARP at a loss. In that form, the program would do very little for banks' No. 1 problem: Their leverage.

Under a revision engineered by U.S. Treasury Secretary Henry M. “Hank” Paulson Jr ., TARP was re-cast to involve direct capital injections into banks. If the bank's desired leverage is 12 to 1, then $10 billion of new capital allows it to support an additional $120 billion of assets, reducing its leverage problem far more than would $10 billion of asset sales. With Britain and other countries making similar capital injections, the LIBOR market has this week greatly improved. The interbank market liquidity problem has not gone away altogether, but has been rendered much less serious.

Over the next few months, there is likely to be more differentiation in the market. At one end of the continuum will sit a majority of good banks, for which the government's capital has removed all danger, meaning these institutions will try to expand their lending business in a market where lending is much more profitable. Their new profits may not help shareholders much initially, as losses still will be caused by old problems being written off. But in the long run, these banks will provide very attractive returns for shareholders – paying off their government capital once market conditions have eased fully.

At the other end of the continuum will sit a small group of banks that face a very disheartening reality: The old problems on their balance sheets are larger than the total amount of the new capital they have received and the money they can earn from new lending. As the market discovers these banks' more severe problems, the LIBOR rates for different banks will diverge, as they did in 1974. The bad banks will find it more expensive to attract funding, their profitability will decline further and they will become uncompetitive on the best new lending opportunities. Eventually, they will be forced out of the market, either through bankruptcy or some other process that culls the weak players from the strong. [For a related story that details how the U.S. loan market is looking brighter for creditworthy firms -- even as it gets darker for firms perceived as being bigger risks -- check out this related story elsewhere in today's issue of Money Morning .]

For the rest of us, we can rejoice that the government's capital injections have solved the problems of most banks, and look forward to lending conditions finally easing a bit in the months to come. That hopefully will prevent the U.S. and global economies from sliding into Great Depression II.

It also should create some very good values in stocks. But maybe we should look at industrials – that carry very little debt – as opposed to banks, at least until the market has sorted out precisely which banks will survive long-term.

[Editor's Note : When it comes to investment banking and the international financial markets, Money Morning Contributing Editor Martin Hutchinson brings readers a unique brand of expertise. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo.  Hutchinson warned Money Morning readers about the dangers of credit-default swaps back in April – long before the collapse of American International Group Inc. (AIG) made the a household word – and his recent analysis of how the U.S. stock market would respond to the credit crisis proved to be incredibly accurate. Hutchinson is also a regular contributor to our monthly investment newsletter, The Money Map Report . And right now, new Money Map subscribers can receive a free copy of the Jim Rogers best-seller, “ A Bull in China ” – which, ironically, details investment plays in the one market – Mainland China – we believe offers investors the best possible returns for the next few years to come. ]

News and Related Story Links:

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in