Why Libor Is the Key

After yesterday’s rate cut, I would have thought that interbank lending rates would have come down by a modest amount.  I was wrong.  Instead, this is what happened:

Libor Dollar Rate Jumps to Highest in Year; Credit Stays Frozen

Overnight LIBOR and commercial paper rates came down big.  But 1-week,, 1-month and 3-month rates went up… a lot.  If you want to know why LIBOR has had me so worried for so long, read this:

Libor Holds Central Banks Hostage as Credit Freeze

Here’s the bottom line: Volatility is so high that we’re likely to soon have a monstrous oversold bounce.  Also, the authority that the FDIC now has – the ability to declare a systemic risk and not follow the least-cost method when rescuing banks – should give investors confidence that lending to US banks is not going to blow up in their face.  This is huge, and it’s something that I’ve mentioned repeatedly in this blog.  Add to that the soon-to-be-implemented TARP plan, the Fed’s decision to buy commercial paper, the ECB publicly stating that it will cut rates if necessary, Britain’s decision to inject capital into banks, and a whole host of other measures, and we should, SHOULD see the LIBOR rate decline, which would be a huge boost.

To bet against LIBOR coming down is to bet against every central bank and every taxing authority on the planet.  So here’s what I am watching.  If, when we do get the bounce higher, neither LIBOR nor commercial paper rates decline, then we’re in for some very deep problems.  If, on the other hand, LIBOR and commercial paper rates do decline, then we will have started to move in a very positive direction and set the road to the financial system’s recovery.

Can We Blame Libor on Lehman?

I’ve been hearing this bandied about for a while now.  It’s now gone mainstream in the Financial Times and commented on by The Big Picture, and it makes sense.

Q: Why are banks hoarding cash even when the Feds have said they’ll backstop the commercial paper market, inject capital, buy bad assets, etc?

A: Banks need to have the cash on hand to settle what could be a colossal Lehman CDS settlement.

Read this if you want to learn more about what might happen.  That said, it’s not for the novice.

There’s one important thing to realize about a CDS settlement — it’s a zero-sum game.  It’s not like stocks, where stock price declines cause real loss of wealth.  With any derivative, for every dollar someone wins, someone else loses.  At least that’s the way it works in the listed derivatives market.

If this goes well, then perhaps we’ll see those LIBOR rates come down.

What’s really interesting is when you put this into the perspective of what Paulson said yesterday. The FDIC has taken the position that the rescue law allows it to abandon the least-cost method when dealing with a failed institution.  Also, the Treasury is now considering injecting capital directly into banks.  One more thing: Why did AIG, one of the bigger underwriters of CDS, suddenly need another 38 billion?  Looks like everybody is gearing up for something big.

Comments

[NutritionFacts:]

Good piece.

2008 Oct 09 12:25 PM

[ObjectiveFu...:]

I think JasonC predicted this development, oh, about two weeks ago. I quote him:

"The decision *not* to give loan guarantees on Lehman mortgage debts to allow the rest of the bank to be sold in an orderly manner, has already cost 30 times what a 'bailout' would, any counting. Without stopping any of it, as that would have. Paulson simply listened to the screamers and there is hell to pay in consequence.

"This will cost all of us an extra $500 billion easy, and probably more like an extra $2-3 trillion. It was world-historically stupid. Shrinking the money supply in 1932 stupid. It will be studied for generations as exactly the way *not* to run a lender of last resort operation."

2008 Oct 09 12:50 PM

[Zingfer:]

The CDS market is supposed to be a zero-sum game; however, there are entities that will be unable to pay; hence, solvent entities can loose money even though they appear to be fully hedged...

2008 Oct 09 04:15 PM