Friday, October 3, 2008

Labor over Libor

Is the LIBOR correctly reflecting the true nature of the unfolding credit crisis? Every once in a while skepticism would give way to discussion, only to be forgotten later. The rate is now under scanner again.

Usually, overnight LIBOR is a little over the Federal Reserve's benchmark rate - the Fed Funds rate. The prevailing LIBOR is now 400 basis points above Fed’s target rate of 2% - reflecting that the banks are not lending to each other and whats more interest rates may adversely impact borrowers. These are historical highs ever since the British Bankers Association has started tracking it since 2001.

Like this Bloomberg story says “Libor, set every morning in London, is what banks pay to borrow money from each other. That in turn determines prices for financial contracts valued at $393 trillion as of Dec. 31, 2007, or $60,000 for every person in the world, and helps set consumer interest rates on everything from home loans to credit cards.”

The spread between the 3-month LIBOR and the overnight indexed swap (OIS) rate was less than 15 basis points. Since August the spread has increased as much as five times. A recent report by Merrill Lynch said that following the Lehman Brothers bankruptcy filing, the spread has moved up to 166 basis points, and has now been above 200 basis points for four straight days.

An indicator of whether the ‘near-term’ crisis has passed will be if the spread cuts by 100 basis points according to Merrill. “We do not expect to see a move back to the 11 basis point norm anytime this year or next," it has said.

Another crucial barometer in the on-going crisis is the TED spread - the difference between the benchmark London Interbank Offered Rate and US Treasury Bill rates. The success of the bail-out package will be judged by how this barometer jumps since it reflects inter-bank counter-party risk.

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