Even though the Fannie and Freddie near crisis, which produced a few days of panic in the credit markets, now seems to have abated, money market investors are still on edge. The Financial Times warns that various risk measures remain at elevated levels:
Libor, the measure of inter-bank interest rates that is a key barometer of the health of the credit markets, continues to signal problems a year into the credit crunch and raises doubts about whether the financials’ share prices are close to a bottom….There is a growing realisation that the all-clear signal for the banking sector will not sound until the difference between Libor and the overnight rates set by central banks narrows from its current elevated levels.
“The persistence of fear one year later remains very troubling,” says Jim Paulsen, chief investment strategist at Wells Capital Management. “The equity market is still fearful and that is fanned by what investors see in the present level of Libor, credit default swaps and interest rate swap spreads.”
Swaps, which measure the expected difference between overnight rates set by central banks and three-month Libor, remain wide. In the US, the so-called Overnight Index Swap (OIS) is about 73 basis points, while in the UK it is 67bp and 62bp for the eurozone. Prior to the credit crunch last summer these swaps were trading around 15bp.
At least the situation appears no longer to be deteriorating. OIS rates have pulled back from their peaks of around 100bp touched last December and during the weeks leading up to the collapse of Bear Stearns in March.
“We are not seeing widening pressure in Libor, which is the only silver lining at the moment,” says George Goncalves, strategist at Morgan Stanley. Over time, he expects that OIS swaps should narrow to around 35bp but adds that forward starting swaps for 2009 currently indicate the swaps will only ease to around 50bp next year….
At the heart of the elevation in Libor are concerns over the health of bank balance sheets, where weakness can spill over into the broader economy because it limits the availability of credit to companies and consumers.
“Libor has been a barometer of the need for banks to raise capital,” notes Dominic Konstam, head of interest rate strategy at Credit Suisse. “The main problem with Libor is the capital strains facing banks.”….
“The first shock was specifically about writedowns at the banks,” says Mr Goncalves. “Now it is about ascertaining what their balance sheets are worth in an environment of declining credit availability.”
Such worries about the health of banks and their need to raise further capital will keep money markets on the defensive, with institutions reluctant to lend to each other. That restriction in lending is now filtering through to the broader economy and poses a threat to future growth.
“We now face something worse than elevated Libor and the deleveraging of the financial system, and that is an outright recession,” warns Mr Konstam.
Some of the problems seen in Libor stemmed from banks in Europe who required dollar funding in order to finance their holdings of dollar assets. As the funding strains grew, so institutions sought to borrow in the euro and sterling money markets. This pushed money market rates higher in the major currencies, a situation that still persists.
Earlier this month, the European Central Bank auctioned $25bn to banks and attracted heavy demand.
Meanwhile, US banks continue to borrow for a period of 28 days from the Federal Reserve’s TAF program, and a total of $150bn is outstanding….
Quick fixes are now no longer part of the discussion.
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S T R E S S??
WSJ says:
Shares of Merrill Lynch & Co. Inc. led the financial sector lower, dropping 11.5% amid heavy activity among bearish investors in the options market. The stock hit a 52-week low of $24.26 a share and ended at $24.33 a share, as last week’s brief relief gave way to more insecurity. But options analysts had a hard time pinning down the reason behind the decline, as Mike McCarty, options strategist at Meridian Equity Partners, says there was “nothing to explain the pick-up in implied volatility.” Same goes for the credit markets, where credit-default swaps of Merrill, which measure the cost of insuring its debt against default, rose to $355,000 to insure $10 million in bonds against default for five years, up from $310,000 Friday, according to Phoenix Partners Group. Heavy bets were made in both August and September options, with more than 11,000 put options changing hands at the September $22.50 strike price. “We’re starting to see 10% moves as not uncommon on a daily basis,” says Chris Rich, Newedge Group senior options strategist.
The USD money market isn’t bad at the moment. The real borrow rate is less than 20 bips over Libor and under 3%. So it’s not back to normal, but it’s not signalling any disasters to come.
reg LIBOR rates
The FT article barely scratches the surface. We know that LIBOR is an artificial indication of a practically no- longer-existing lending form (threee month unsecured interbank lending).
We know that WEstern banks refinanced themselves to a big estent with Asian money which lent in some accordance to LIBOR.
This is over. Real LIBOR rates would certainly look higher, maybe 200 or 300 Basispoints instead of 70.
Nobody want to show or see those spreads. So the central banks fund the commercial banks and commercial banks pretend they lend to each other for three months at spreads around 70 – and pocket this spread in their variable lending rates.
So far so good. But where do we go from here? The FT article implies that we have to get back to old spreads (15-20 BP). This looks nonsensical in the current environment. There is no way this can happen without first recapitalizing and/or nationalizing the big banks.
Any scenarios in this braintrust?
I think it’s important to remember that LIBOR is unsecured + banks simply do not trust each other = wide spread. Nobody trust them – you can see the same thing in bond spreads, i.e. BBB US banks to Treasury, which has widened from ~100 bp a year ago to 340 today. Or look at bank CDS spreads.
Secured lending (repo) backed by quality collateral (blue chips, Sovereigns) has widened over the same period by 20-30 bp with no changes in haircut, margin calls etc. The banks just don’t have good quality collateral to use, partly as a result of all the CDO etc. crap on their books and partly as a result of the nature of their business.
Time heals all wounds. At some point in the future, only (mostly) quality collateral will remain, and we should know who’s holding what. At that point, LIBOR spreads should narrow, but banking activity should be much less, as a result of deleveraging.
Other than that, I don’t see any miracle cures. Central Banks swapping crappy collateral for Sovereigns certainly helps on the margins, but there balance sheets are just not big enough to save all the banks.
– Meanwhile, I see US banks in Europe are slightly up (11:00 GMT), although liquidity there is worse. We’ll see what happens when the US opens. Maybe the worst is behind us :)
There is so much vague writing on this subject (Francesco Giavazzi’s piece on RGE was similarly sloppy) it is hard to make much of it. My understanding (someone please correct me if I am wrong) is that an OIS rate is the fixed side of a swap against the overnight policy rate. This is (abstracting from details like whether the difference is exchanged daily or at the end of the contract) is practically the expected policy rate for the period of the swap. In other words, the OIS rate tells you about monetary policy expectations and not much about credit/liquidity. Where the policy rates that the OIS swap refers to are repo rates, the spread between the swap rate and the LIBOR rate FOR THE SAME TERM, does tell you something about credit/liquidity. Comparing three month sterling and euro LIBOR rates with the overnight policy rates (as the FT does) is therefore only a poor (noisy) “barometer of banks’ need to raise capital”.