Asian money markets, counterparty risk, and the TED spread:
Keeping the world financial system operational
By Jon Fernquest |
The last few days have provided a frightening opportunity to observe how financial markets behave under extreme stress.
An emergency room scene with a doctor rushing to get the patient's heart beating at any cost, using any means available, is perhaps the closest analogy.
Central banks are frantically trying to get banks lending to each other again. As markets stall and grind to a halt, central banks are injecting liquidity into them, jumpstarting markets, to get people trading again. As economist Paul Krugman describes the current situation in today's New York Times:
...the real shock after the feds failed to bail out Lehman Brothers wasn’t the plunge in the Dow [stock market], it was the reaction of the credit markets. Basically, lenders went on strike...This flight to safety has cut off credit to many businesses, including major players in the financial industry — and that, in turn, is setting us up for more big failures and further panic. ...(Source: New York Times via Economist's View Blog)
The interbank lending market in Asia is also suffering. The headline for today's article below says it all: "Asian Money Market Rates Jump Even After Central Banks Add Cash."
Liquid markets and liquidity risk
A "liquid market" is a market with enough buyers and sellers that a trade can be made if you need to make a trade. "Market liquidity" means trades can be made.
"Liquidity risk" is the "risk of loss as a result of a lack of market liquidity, preventing quick or cost-effective liquidation of products, positions, or portfolios" (Source: New Zealand government glossary). The opposite of a "liquid market" is an "illiquid market" where the necessary trades cannot be made.
The TED spread
The TED spread measures how willing banks are to lend to each other.
Defined as the difference between the yield on three-month U.S. Treasury bills and the three-month LIBOR rate, the greater the Ted spread the more unwilling banks are to lend to one another.
Recently, the TED spread has increased to record levels because banks feel unsafe lending to one another.
Banks would rather keep their funds in safe assets like short-term US government debt, traditionally a safe haven for money. Three-month rates on T-bills have dropped to their lowest level since at least 1954. See Paul Krugman's blog for a graph of this "liquidity trap."
First lets looks at some of the rich vocabulary that is being used to describe this financial "emergency room" drama. There are many other ways of expressing the idea of liquidity or lack of liquidity in markets:
* a thin market
* a thinly traded security
* illiquid securities
* difficulty in raising funds to meet commitments
* lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss
* securities cannot be converted into cash, because of reduced access to or demand from the market
* the ability or inability to sell and collect the proceeds for a specific asset
* a large spread between the bid price and ask price quoted by the dealer
* situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade
(Source: Google definitions)
The market liquidity for lending funds between banks (inter-bank lending) has decreased also. Here are some of the phrases used to express this idea in in the article below:
* a credit crunch
* the reluctance of banks to lend money to one another
* reluctant to lend even after cash injections by central banks * panicky banks
* lenders hoarding cash
* a loss of confidence in credit markets
* a flight to safety
* abandon higher-yielding assets for the safety of the shortest-term government securities
* nervous about counterparty risk
* the premium for cash will remain high
Here is the article in full:
Asian Money Market Rates Jump Even After Central Banks Add Cash
By Candice Zachariahs and David YongSept. 18 (Bloomberg) -- Money market rates surged in Asia's biggest financial centers as the collapse of Lehman Brothers Holdings Inc. and American International Group Inc. made banks reluctant to lend even after cash injections by central banks.
One-month interbank rates in Hong Kong more than doubled to near the highest in a year and the rate for three-month dollar loans in Singapore surged to an eight-month high...
"Banks are unwilling to deal with each other in the interbank market," said Sean Keane, regional head of short-term interest rates in Singapore at Credit Suisse Group. "Everybody is extremely nervous about counterparty risks. The premium for cash will remain very high."
The Bank of Japan pumped in 2.5 trillion yen ($24 billion) today and the Reserve Bank of Australia added A$3.02 billion ($2.4 billion) to ease a credit crisis. Yesterday's injection of $33 billion by both nations and similar measures across Asia failed to prevent rate increases in some major markets as U.S., European and Australian lenders hoarded cash.
Hong Kong's one-month interbank rate jumped to 4.829 percent from 2.234 percent yesterday, the highest since October 2007. The Hong Kong Monetary Authority injected HK$1.556 billion ($200 million) into the banking system today, it said. Singapore's three-month dollar loan rate surged 50 basis points to 3.525 percent at today's fixing, according to the Association of Banks in Singapore.
Interbank Rates
In Australia, the difference between the rate banks charge each other for three-month loans and the overnight indexed swap rate, which measures the availability of funds in the market, rose to 80.8 basis points, or 0.808 percentage point, at 5 p.m. in Sydney, from 59.67 basis points yesterday.
The spread stood at 78.25 on March 11, after Bear Stearns Chief Executive Officer Alan Schwartz denied the firm lacked sufficient capital. JPMorgan Chase & Co. agreed to buy Bear Stearns a week later...
The London interbank offered rate, or Libor, yesterday rose 19 basis points to 3.06 percent, the British Bankers' Association said, the biggest increase since September 1999. The jump in Libor widened the TED spread, or the gap between what the U.S. and banks pay to borrow in dollars for three months, to 3.02 percentage point, the most since Bloomberg began compiling the data in 1984.
Bank Losses
Japan's overnight loan rate rose to 0.655 percent before the central bank's injections and was at 0.2 percent as of 3.54 p.m. in Tokyo. The BOJ's target rate is 0.5 percent.
"There is a credit crunch everywhere, even in Japan, but it's relatively better here as Japanese banks are still okay," ... "Domestic institutions don't want to give money to foreign institutions, so the BOJ stepped in to stabilize the market" ....
Repricing Risk
"This is a function of the global scenario and that there is a re-pricing of bank risk going on globally," ...
Bank of Japan Governor Masaaki Shirakawa downplayed concern that the U.S. banking crisis will hurt the world's second- largest economy and said Japan's financial system remains stable.
"Most lending to Lehman Brothers was made by major Japanese banks and their potential losses seem to be within the levels that can be covered by their profits," Shirakawa told reporters in Tokyo yesterday....
(Source: Bloomsberg, 18-09-08, temp-link)
Vocabulary:
money markets (definition #1) - the markets where money and other liquid assets such as short-term government bonds can be lent and borrowed for between a few hours and a few months, different from capital markets where longer-term funds changes hands (See The Economist glossary)
money markets (definition #2) - the global financial market for short-term borrowing and lending, providing short-term liquid funding for the global financial system, where US government Treasury bills (short-term bonds), commercial paper and bankers' acceptances are bought and sold
the interbank market, interbank lending market - the market for lending temporary funds between banks, a high-level foreign exchange market where over 1000 banks can exchange different currencies for short periods time (See Wikipedia)
one-month interbank rate - the interest rate for making one month loans of funds between banks
overnight indexed swap - an interest rate swap, a type of derivative (See Wikipedia)
a counterparty - a company with obligations to you under a contract, a promise to make payments at certain times
counterparty risk - the danger that one party in a trade can't pay its losses, the risk that payments agreed will not be made, default risk, credit risk (See graph of escalating counterparty risk in latest issue of The Economist)
TED spread - the difference in yields between inter-bank and U.S. Government loans, between the three-month U.S. Treasury yields and the three-month LIBOR rate (See Wikipedia and Reuters's article)
yield - the interest rate of an investment such as a bond, the annual income from the investment expressed as a percentage of the current market price (when bond prices go up bond yields go down, a flight to safe short-term treasury bonds means these bond prices go up because demand is greater than supply, this means that these bond yields go down) (See The Economist glossary and US News and World Report)
a credit crunch - when businesses and households can't get loans anymore, banks suddenly stop lending and bond market liquidity disappear after investors and holders of capital seek to avoid risk (See The Economist glossary)
LIBOR, the LIBOR rate - the "London Inter Bank Offer Rate" which is interest rate of London's wholesale money markets, the standard interest rate used in US financial markets, changes less than the prime rate, used to set variable-rate loans including credit cards and adjustable-rate mortgages (Source: DebtConsolidation.com)
liquidity risk - liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit) (See Wikipedia)
liquidation - selling an asset for cash, turning an asset into cash
reluctant to lend - don't want to led money to others
cash injections by central banks - central banks making loans available to banks so they will keep lending among themselves and to their business and household clients
a premium for cash - have to pay extra for safe assets like cash and short-term US government bonds (T-Bills)
lenders hoarded cash - lenders don't want to lend their funds, too risky, keep cash and wait
lacked sufficient capital - the bank does not have enough money generated by stocks (equity) to operate safely
re-pricing of bank risk - with many failing to repay loans, the value of these loans goes down
panic - panic - a sudden strong feeling of fear and confusion (See glossary)
flight to safety - risky assets sold, money put in safe assets like short-term US government debt (T-Bills)
General vocabulary:
operational - continues to function properly, doing the work it needs to get done
an analogy - whoing how two things are similar
frantically - doing something too fast, in a big rush
stall - fail to move forwards, stop operating
grind to a halt - stop completely
jumpstart - quickly start
stepped in (to solve a problem) - enter a situation to solve a problem (a situation you are not normally involved in)
downplayed concern that X - say or claim that X is not really important
