Does the TED Spread Really Matter?

I'm hardly the only person paying close attention to the TED spread right now. Here's a few blog entries about it from Friday alone: 1 2 3 4 5 6 7 8 9 -- there was even a joking fight between Paul Krugman and Brad DeLong about who was responsible for making it "the consensus indicator of the depth of the current financial crunch".

But here's the thing: TED is the spread between three-month Libor and three-month Treasuries. Three-month Treasuries are a classic flight-to-quality buy: the place you go to when you want to just hide out in a cave and not get eaten by a marauding bear. Three-month Libor, on the other hand, is the rate at which banks will lend out their precious capital to another bank for a full 90 days: an eternity, in this market.

More to the point, if you're a bank, you really neither want nor need three-month interbank funding right now. Global central banks, led by the Federal Reserve, have flooded the system with so much overnight liquidity that you can get as much cash as you need, at a much lower interest rate, directly from your central bank, overnight. The choice between that and locking in a high interest rate for three months is a no-brainer.

Remember too that Libor is an indicative rate: it's the rate at which banks would lend to each other, if they were lending. If they stop lending, they still need to report some interest rate to the Libor committee. But it might well bear very little relation to banks' cost of funds in the real world, where the interbank markets are becoming increasingly dried-up and unhelpful.

Henry Blodget has a bank-analyst friend who thinks that the TED spread is crucially important:

The TED Spread, he explained, is 300+ basis points, and unless that changes, the whole system will shut down in a matter of days (the TED Spread measures the difference between 3-Month Treasuries and 3-Month LIBOR and represents how much many banks have to pay to borrow short-term money from each other. Banks either have to borrow or sell assets, the analyst said, and banks aren't going to borrow much at a 300bp TED when that's often bigger than their entire net interest margin.)

I think what the analyst is missing here is that so long as banks can borrow from the central bank overnight, the TED spread is largely unrelated to their real-world cost of capital. Which doesn't make me an optimist, by any means. But I do think that the TED spread can remain elevated for some time without the world coming to an end.

Comments

[Cesar Valencia:]

Question. Isn't this exactly the problem? That the FED wants banks to lend and borrow from each other rather than being the one providing all the liquidity? The system will not collapse, it will just be more reliant on loans from the central bank.

2008 Sep 27 01:43 PM

[dlaw:]

This is a good article, but reaches a myopic conclusion.

If banks are not doing business with each other, the money multiplier goes down - quickly. Financial crises happen exactly because firms and individuals follow courses which are logical for them individually, but destructive to the marketplace.

Just because we can't quantify it easily, doesn't mean the marketplace itself doesn't have enormous ecomonic value. I fear we are going to find out how much value - when we lose the marketplace.

2008 Sep 27 02:29 PM

[investor88:]

Felix's article and readers' comments has shone light on the important subject of TED spread and its possible implications for financial markets.

2008 Sep 28 03:35 AM

[The Simple ...:]

Side note: one of the benefits of the spread for US banks is that, in the real world, many smaller firms lend their excess reserves to the banks at the Treasury rate and borrow at some rate based on LIBOR +, which in effect means that banks can make money on the spread, so long as they are actually borrowing and lending.

2008 Sep 28 11:04 AM

[User 123297:]

felix, how do you make money on your TED spread? thanks,bob

2008 Sep 29 01:14 AM

[michael fro...:]

the banks are acting like consumers that shop at wally world.....everyone is looking for a better deal. just like wally put a few over pricey retailers outta business so to shall the money center bank....life will still go on.

2008 Sep 29 01:18 AM