LIBOR Shows Worst Is Yet to Come for Credit Markets

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.

LIBOR is the rate at which banks offer to lend funds to other banks, based on current interest rates. In many ways, it is similar to the U.S. Federal Funds rate.

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.

Recently, 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%. 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.

The BBA compiles the dollar rate every day from data submitted by 16 banks, including Deutsche Bank AG and Royal Bank of Scotland Group PLC. There are also rates for the euro, Japanese yen, British pound, Swiss franc, and Australian and Canadian dollars.

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. 

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.

Comments

[investor88:]

Useful article indeed on important indicators ie TED spread and LIBOR. We must keep track of this these as part of our navigation tools in the stock market. Agree with conclusion of article that credit markets are under stress which means negative impact on equities.

2008 Oct 16 07:57 AM

[jljamup:]

This is the best article that i have ever read, explaining about Libor and interest rates,and how they work. however i do not know what BBA. means.

2008 Oct 16 08:23 AM

[BBA:]

BBA = British Bankers Association

2008 Oct 16 09:57 AM

[flow5:]

Good. Contract the prudential reserve euro-dollar market.

2008 Oct 16 11:40 AM

[User 265729:]

I have a suggestion. Since Bush-Paulson are really into this big government thing, Bush can just have Treasury name LIBOR a "terrorist organization." They can then be places on the watch list...

Next Bush can refer this to the Pentagon. It is my understanding that the Pentagon has a formula for the number of innocent people that can be killed in air strikes based on the value of the target. Certainly Bush and Paulson can bring DoD to the conclusion that taking out half of the population of London is worth the "American way of life."

Bush will get to brief the American people on the evil-doers at LIBOR and how they've met their maker at the hands of laser-guided air to ground missiles.

The free market system and the American way of life saved. Bush will be greeted as a liberator!

2008 Oct 16 08:04 PM

[Witzy:]

This article presents standard economic theory. However, be cautious with the LIBOR here, since banks are hesitant to trade with each other because of a lack of information or transparency, this is not just about liquidity. LIBOR will remain high so long as banks do not know who they can trust, and that won't change until they know precisely what collateralized debt they have on their own books.

2008 Oct 17 01:18 AM

[Metzenbaum ...:]

Great primer for those not familiar with OIS and LIBOR. Recall when no one knew what CDO meant? Watch for LIBOR and OIS on the Christmas cocktail parties. In Peoria.

As for your first choice of investment, Treasuries. Sure, they appear safe, with a negative return. Personally, I have loaded up on Canadian Gov't bonds. I don't feel much comfort in the long term trend of the US$.

2008 Oct 17 10:14 AM

[Sean Mc:]

I agree with the comments above saying this was a good tutorial. However, I disagree with the prognostication for the credit markets. Central banks and government agencies, including the FDIC in the U.S., have now guaranteed all interbank loans, so there is really no risk of default. There is a 75 basis point fee for commercial banks that want the guarantee, so it is an arbitrage play for banks to borrow from the Fed at all-time low rates and lend to other banks at large spreads without risk. Furthermore, central banks are injecting equity directly into commercial banks, deleveraging them and providing a further incentive to lend. I think it is all but inevitable that the spreads are going to narrow dramatically within a couple of weeks.

2008 Oct 17 01:21 PM