Crocodile tears and the LIBOR-OIS spread
OK. So, stock markets are, like, tanking.
But the new conventional wisdom has it that stock markets aren’t really where the action is. To gauge how the crisis is unfolding, we are told, we should pay attention to credit indicators, particularly indicators that compare the cost of interbank lending to the cost of “risk-free” government borrowing, such as the TED spread.
Felix Salmon has done a nice job of pointing out the flaw in these indicators: Banks don’t actually have to borrow at the elevated interbank rates, as long as central banks are willing to lend directly at much lower rates. So, it’s unclear whether interbank borrowing rates like LIBOR are meaningful as measures of interbank counterparty risk. As Felix notes:
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.
What is very clear is that LIBOR serves as the basis of many thousands of private sector contracts, and that the banking system as a whole is a net receiver of LIBOR-indexed funds. To the degree that LIBOR does not reflect banks effective cost of funds, an elevated rate can be viewed as a hidden tax of the nonfinacial sector by banks. Rather than reflecting the banking system’s pain, a high LIBOR might indicate banks’ ability to leverage their collective insolvency to charge higher rates on nonfinacial firms without complaint.
The oddest duck in the credit indicator menagerie is the LIBOR-OIS spread. That’s a measure of the difference between what banks claim they have to pay to borrow from one another and what the market actually expects they would pay, if they adopted a strategy of borrowing overnight from, err, one another in the Federal Funds market. Both legs of the LIBOR-OIS spread represent unsecured interbank lending, so it’s not obvious how this measure captures counterparty risk. It does, to a degree, because counterparties of a bank rolling overnight loans can choose not to renew the credit, should bad news strike, while a bank that extended a term loan at 1-month or 3-month LIBOR can do nothing but watch the fall. In a sense, LIBOR-OIS can be viewed as the price of an option to call a loan, to the degree that LIBOR accurately reflects the cost of interbank term financing.
But since US banks can borrow from the Fed’s discount window at the Federal Funds rate + 25 basis points, while adjustable rate loans from banks are often indexed to LIBOR, a simpler way to think of the LIBOR-OIS spread is as a measure of the difference between the cost to banks of central bank money and rate they charge on private loans. Put this way, it is hard to understand why banks are upset that this indicator is elevated.
If this seems overly cynical, it’s worth considering what happened to a LIBOR predecessor, the Prime Rate during the last US banking crisis.
Great post steve.
i agree that LIBOR is no longer the measure it was, and that many of the old measures have stopped telling us what they used to given how large a role the Fed now plays in lending and borrowing.
i don’t think that a permanently higher LIBOR is something the US Gov’t will gift the financial sector, as many adjustable rate mortgages are tied to LIBOR. Given the political excitement around “making payments affordable” and “keeping people in their home”, adding 3% to a mortgage rate adjustment is just too obviously counterproductive
October 12th, 2008 at 2:23 am PDT
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Quite illuminating.
Steve, I am most interested in your view as to why about 150 years and quite a few financial crises since Lord Acton declared that “the issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks”, the people continue accept such abuses of their trust. If it hasn’t happened so far, what basis is there to think that it ever will (you know, the ole “this time it’s different”.)
October 12th, 2008 at 3:39 am PDT
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Well, yes, but you have only a third of the story here.
I have been wondering for a long time when someone outside capital markets would actually wake up to the fact that IBOR rates are not mainly funding costs, which they are not and have not been for a good 10 years, but mainly a use of funds rate, and thus why its level should relate to the banking system’s AL structure.
The first of the other two important points is that Libor was unwisely chosen as a reference rate for the central interbank swap market – a choice derived from the fact that the US have never been able to bring their payment system out of the Middle Ages and get themselves a vaguely efficient payment system and Fed Fund market, so that the rational natural index (Fed Funds) never was an option. So, with Libor out in the wild, the credit markets are crippled.
The other one is that IBOR rates firmly belong to the past. There is no unsecured interbank lending going on anymore, well not for any size, and the concept had become exotic long before 2007 made it disappear altogether. I do not see the point of an index which does not trade, except for manipulation purposes. It should be thrown away for good. It has become not only irrelevant but a severe hindrance to the basic functioning of the interest rate markets.
October 12th, 2008 at 7:59 am PDT
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Fed currency swaps are the source of dollar liquidity provided by non-Fed central banks. I suspect bank balance sheet Libor loans greatly exceed the currency swaps on the Fed’s balance sheet (embedded in “other assets”). If so, there is a question as to how the system is funding the difference, although arguably the most acute phase of the funding crisis has yet not worked its way through a full repricing and refunding cycle for these loans. Still, I doubt currency swaps will blow up anywhere near enough to fund global Libor funding needs.
Many foreign banks clear US dollars transactions through US correspondents in New York. Large net “overdraft” positions may be showing up in US banks as a result. This transfers part of the Libor funding problem to New York banks that must cover positions in the fed funds market or otherwise. The rates on these overdraft positions might be quite punitive – Libor plus a spread.
I think there is a sort of credit spread embedded in Libor – OIS. Again, most foreign banks borrowing in the Libor market can’t access the Fed funds market directly. And I suspect the US operations of the larger ones who can are constrained by regulation in using fed funds to finance non-US operations (i.e. “up streaming” fed funds borrowing). To that degree, Libor-OIS is an interesting spread, but not really a comparison of two alternatives. That may complicate the implied option economics as well.
October 12th, 2008 at 8:37 am PDT
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As I posted on Nakedcapitalism the other day – The real problem is that LIBOR is NOT an actual market interest rate, it is an arbitrary number posted by the BBA based on a survey of a handful of its members. There is no reason for US financial institutions to continue linking mortgages or other instruments to LIBOR.
October 12th, 2008 at 9:17 am PDT
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If there is no demand for these interbank loans why is the price not going down?
October 12th, 2008 at 10:06 am PDT
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Steve – great insight.
A question on the Prime Rate being fixed at an elevated 3% above Federal Funds:
Your post on the Prime Rate referenced Greenspan doing this in the early 90’s. But, isn’t Prime set by banks rather than the Fed ? And in all that time, amid the explosion of cheap credit and drive for higher profits, wouldn’t at least SOME banks have broken that cartel leading others to follow them down ?
I have trouble believing that a cartel has managed to hold a set rate for so long (18 years?) although I see no other explanation…
DO you have any insight on this ?
October 12th, 2008 at 10:23 am PDT
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Murph – The Prime rate, like LIBOR, is a made-up rate. It’s based on an index of what a number of large banks SAY they charge their best customers. In reality, those banks (and other banks) charge rates both above and below Prime to their best customers.
October 12th, 2008 at 12:29 pm PDT
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A bank is a bank only if it lends money. If banks are trying to lecverage their collective insolvency to charge higher rates to non-financial sectors then the government may have to consider capping interest rates. If the banks continue to refuse to loan money then their charters should be revoked and the FDIC should step in and nationalize the errant institutions.
October 12th, 2008 at 12:36 pm PDT
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Libor-OIS measures counterparty risk because in an OIS transaction, counterparties’ exposure to each other is limited to the difference between the fixed and floating rates being swapped. There is no exchange of principal in an OIS transaction — counterparties only exchange the spread between the fixed and floating rates. This spread is usually so small that counterparty risk is almost negligible. By contrast, there’s much more counterparty risk in a normal interbank Libor loan, because the lending bank might lose both the principal and the interest if the borrowing bank defaults (but you obviously know that). The difference between Libor and OIS thus reflects the amount of counterparty risk in Libor.
(There’s actually good evidence that the Libor-OIS spread reflects counterparty risk almost exclusively, and doesn’t really reflect liquidity risk at all; yet the media still reports the Libor-OIS spread as a measure of cash shortage, and hardly ever mentions the counterparty risk reflected in Libor-OIS. Go figure.)
I don’t think that’s right. In an OIS transaction, the parties exchange the difference between the fixed and floating rates only at maturity. The floating rate that’s eventually paid at maturity is based on the overnight index rate over the term of the swap (generally the geometric average of the overnight index rate), but no money actually changes hands until maturity. So I don’t know how the counterparties can “choose not to renew the credit” in this situation. Or am I misunderstanding you?
October 14th, 2008 at 7:06 pm PDT
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EOC — Rightly or wrongly, I’m not considering the OIS swap transaction directly, but presuming its price is a best estimate of a what-if: what if a bank entered into a cash transaction lending or borrowing in the Federal Funds market and rolling over for a month or three. That’s the underlying exposure OIS swaps are designed to hedge, they are really just vanilla fixed/floating interest rate swaps, exchange floating FF exposure for a fixed rate. If they are priced well, OIS represents an equivalent fixed rate to adopting a cash-market strategy.
I am not interested in the counterparty risk associated with the swap transaction, except to the degree that it might be asymmetrical and affect the price. If you want to, you can argue swap counterparty risk or other details of the OIS market mean that its price is not a fair measure of the expected cost of rolling a loan in the Federal Funds market (and I’m very open to learning that’s true). But if the price is right, I don’t otherwise care about the actual cashflows of the OIS transaction, which as you say are net and involve no principal.
The counterparty risk I am interested in is the counterparty risk faced by cash-money Fed Funds lenders, which should be priced into the OIS swap rate. Do you think that it is not?
October 14th, 2008 at 7:21 pm PDT
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Steve:
fed funds are for reserves balances held at the fed, you can’t fund your book at the fed funds rate. you can do it at fed funds+ at the discount window or TAF but that needs collateral with haircut, the wider the range collateral taken by the fed, the less there is left to cover unsecured lenders in case of defaults, so the riskier it is to lend unsecured, that will only change when the banks are recapitalized and the toxic waste is off the books.
October 17th, 2008 at 4:00 pm PDT
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jck — yeah, my argument presumes that banks have collateral by which they can fund at FF + 25 via discount borrowing, under what I think are justifiable assumptions that the Fed is overvaluing (under-haircutting) collateral dramatically (against a mark-to-market-bid baseline) and that at least for systemically important banks, they are lending freely and not letting the increasing riskiness of the Fed’s balance sheet constrain the availability of discount window financing.
October 17th, 2008 at 4:17 pm PDT
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Steve:
They certainly are lending freely, and if they do what you think (quite reasonable btw), then lending unsecured is risky, and libor reflects that, not accidental that libor-OIS has widened every time they come up with a new scheme to improve liquidity.
October 17th, 2008 at 4:33 pm PDT
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yup… as you say, lending unsecured to banks is risky, so charging a lot for it is sensible, and hobbled interbank lending is systemically sustainable as long as CBs take up the slack. but it is icing on the cake that an appropriately high LIBOR translates to unusual profitability for variable-rate loans outside to those without access to CB funding.
other than for the mercy of LIBOR-indexed borrowers, i don’t know why we should want interbank lending conditions to improve. if they do so by way of a gov’t guarantee, interbank lending provides no evidence of a trustworthy system, nor will interbank lending differentially reward better banks with lower rates. we’ve fallen into a new architecture, yet we seem to be striving to recreate the form of the old one, even though the virtues of the old system (private sector arrangements, market-disciple) have ended.
October 17th, 2008 at 6:42 pm PDT
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You certainly can fund your book with fed funds. That’s what the fed funds rate means – it’s the rate for fed funds bought (borrowed) or sold (loaned). It’s true it’s not advisable to use fed funds borrowed as an ongoing source of funding, given the fact that the Fed controls the supply of reserves available to banks in total, and especially in the current environment where banks are hoarding reserves. The discount window is a more reliable and more available source right now because of this hoarding. But fed funds are “for reserves held at the Fed” no more than any other source of cash. Every transaction affects reserves, not just the fed funds market.
October 17th, 2008 at 9:15 pm PDT
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“Funding your book” with fed funds just means you’re otherwise overdraft at the Fed and must borrow fed funds to cover the position.
October 17th, 2008 at 9:20 pm PDT
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If you accept (A) that we are in a panic, and (B) that investors are not rational in a panic, then (C) Libor spreads and other rate spreads are not rational–but there may be an element of shrewd rationality in them (for some).
The current system propagates the socialization of losses and the privatization of gains, and especially rewards the FOBAPs, the Friends Of Ben And Paul.
If the problem is that banks are afraid to lend to banks that might fail (post-Paulson and Lehman) then why don’t the examiners do their jobs and close the banks that are insolvent? Or make it clear that they’re *not* going to close them, a la the ‘Eighties Latin debt crisis?
We have an example of unconscionable cunctation here.
As confidence returns–and it will, as we are again at generational lows per the Michigan survey–these spreads will diminish and it will all seem like a bad dream. The severity of the recession will be on a par with 1990-1991.
October 18th, 2008 at 10:59 am PDT
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