Holy jumping Libor Rates! And Ted Spreads too!
The risk to short-term market liquidity in credit markets
By Jon Fernquest |
Libor rates soared to new highs after the financial rescue package was defeated yesterday (Read reports at Google News).
How is this dangerous for the US and world economy?
The ongoing US financial crisis actually consists of two separate problems:
1. Short-term market liquidity in credit markets (money markets)
[Keeping credit markets functioning. Avoiding a liquidity trap]
2. Recapitalization of banks.
(Source: Crisis on Wall Street panel at Princeton).
Soaring Libor rates are dangerous for short-term market liquidity (#1 above).
In the short-term look at money markets, not the stock market
People have kept their eyes glued on the stock market recently, looking for new developments in the US Financial Crisis.
The stock market is not the right place to look.
Money markets are where companies and banks meet most of their short-term financing needs.
People should be looking at money markets instead of the stock market. The Libor interbank lending rate as well as the TED Spread measure how well money markets are functioning.
The TED Spread is just the difference between the 3-month Libor rate and the 3-month US Treasury bill or T-bill rate (very safe US government short-term debt). T-bill rates have been near zero recently because so many have been using them as a safe place to put their funds, so that the TED Spread and the 3-month Libor rate have moved up and down together and become almost the same (See graph of Ted Spread on the right and read article).
(Graph on the right shows the recent jump in the Ted Spread)
Recently money markets have become very important indeed. Before their recent failure investment banks were rolling over as much as 25% their total funding on a daily basis in a part of money markets known as the overnight repo market.
In using such short-term funding they ran a high risk of not being able to obtain these funds and becoming insolvent (funding liquidity risk) which is exactly what eventually happened. As of last week they no longer exist (Read Markus K. Brunnermeier, "Deciphering the 2007-08 Liquidity and Credit Crunch," Journal of Economic Perspectives, 2008 (forthcoming) and slides).
The Libor rate
The Libor rate is the key interest rate measuring the availability of funds in money markets. The Libor rate is interbank lending rate. It is the interest rate that banks offer to lend unsecured funds to other banks in the London wholesale money market (interbank market).
After the financial rescue package failed to pass the US House of Representatives yesterday, many banks panicked and hoarded cash, refusing to lend it to other banks. This drove up the Libor rate to 6.88%, quite high compared to last week's 2.95%. There was even one case of desperate banks paying 11% for $30 billion in funds from the European Central Bank.
The Libor rate is an interest rate for the highest quality borrowers with the least chance of defaulting on a loan. Interest rates for other more risky borrowers are given as Libor plus a risk premium:
"More than half of U.S. adjustable rate home loans (ARMs) are tied to Libor, so a recent increase in this benchmark rate mean monthly mortgage payments will rise for affected homeowners if the rise is sustained. A typical adjustable rate home loan will adjust based on the six-month Libor, plus 2 to 3 percentage points. Plus, many home equity lines of credit, small business loans and student loans also use Libor as an index. Student loans, for example, can be set based on the three-month Libor rate plus, say, 4 percentage points or the one month Libor rate, plus 9 percentage points."
If the Libor rate goes up then other interest rates will likely follow.
if ARM interest rates are reset even higher this could lead to more defaults and foreclosures, deflating the US housing bubble even further.
Read a previous article on market liquidity in money markets.
(Source: USNews and World Report, 30-09-2008, link)
Vocabulary:
Libor, the Libor rate - the most important inter-bank lending rate that drives other interest rates (See Wikipedia and another simple article)
money markets - financial markets for short-term borrowing and lending, markets where short-term liquid assets such as money and government treasury bills are traded, the opposite of long-term capital markets, the core money market consists of banks borrowing and lending money to each other using commercial paper or repurchase agreements
Holy [put anything you want here] ! - an exclamation of surprise
market liquidity - how much buying and selling is going on in a market, how easy it is to sell your asset and get cash without taking a loss
a default, in default - fail to pay back a loan, as promised
foreclosure - when the bank takes away the real estate from a borrower that the bank loaned money to
an ARM (Adjustable Rate Mortgage) - a mortgage loan with an interest rate that is adjusted up and down to follow interest rates
ARM interest rates reset higher - initially the interest rate was low to attract borrowers but after some time the rate jumps up making the mortgage difficult to pay back
a liquidity trap - when interest rates are low and monetary policy becomes ineffective (here rates on short-term US government debt have gone to zero)
recapitalization - Restructuring a company's debt and equity mixture often with the aim of making a company's capital structure more stable
the TED Spread - the difference between Libor rates and short-term US government debt (T-Bills)
Repurchase Agreements (Repos) - a borrower sells securities for cash to a lender and agrees to repurchase those securities at a later date for more cash
overnight repo market - the market for borrowing funds with repos for just one day or night
security - assets that a lender will get if a borrower fails to pay back a loan
unsecured funds - money borrowed without security
panicked - a sudden fear that makes you act quickly without thinking
hoarded cash - keep all wealth in cash, not other investments
defaulting on a loan - failed to pay back your loan in time
a risk premium - an extra amount paid for extra risk
adjustable rate home loans (ARMs) - home loans with interest rates that go up or down according to the general level of interest rates
a benchmark rate - an interest rate used to compare and measure other interest rates with
home equity - the percentage of one's home owned after paying back a home loan for a long time
home equity lines of credit - money that you can borrow using home equity as security
a bubble - when asset prices rise far above their actual worth
housing bubble, housing price bubble - when the prices rise to a level much higher than they are worth (often from specualtion because everyone expects to make money from higher home prices in the future)
the bubble deflates, bursts, a housing bust - asset prices suddenly fall from unrealistic levels down to their actual worth
