The Saga of Interbank Banks
Bank and corporate lending rates that price off swap rates have remained largely immune to the palliative of lower rates.
Will Rogers once remarked that: "You can't say that civilization don't advance; for in every war they kill you a new way". In the current crisis, the "new way" is structured credit. Market are also experiencing a sense of Yogi Berra's " déjà vu all over again".
The difference between inter-bank rates (LIBOR or the London Inter-bank Offered Rate or its equivalent in other currencies) and central bank rates or government bond rates has increased sharply. This is making inter-bank and corporate borrowings expensive and is contributing to problems in the credit markets.
This difference is the "swap spread" also known as the Treasury Eurodollar ("TED") spread - the margin between inter-bank rates and government bond rates of the same maturity.
Swap/TED spreads are up 30/40 bps pa to around 60/70 bps. For the worrywarts, here's something to think about - during the 1998 Russian/LTCM episode swap spreads peaked at well North of 100 bps pa!
Central bank rate cuts have had minimal effect on the swap spreads. Bank and corporate lending rates that price off swap rates have remained largely immune to the palliative of lower rates.
On Wednesday 12 December 2007, central banks - the US Federal Reserve, the European Central Bank, the central banks of Canada, England and Switzerland with the support of the Bank of Japan, Sweden's Riksbank and Australian Reserve Bank – took the unprecedented step of conducting auctions to provide funding directly to banks. This was specifically targeted at reducing the swap spread and bringing down inter-bank borrowing costs.
Swap spreads are first and foremost generalized market credit spreads. Historically, they track the credit spread of AA / A rated bonds issued by financial institutions. During good economic times, swap spreads decrease as overall credit risk diminishes. The opposite happens when the economy slows. Swap spreads also increase when funding requirements rise, asset volatility (e.g. equity volatility) increases and financial leverage is high.
During market disruptions, swap spreads are affected by the "flight to quality – the switch to the safety of government securities. Dealers are ruled by the adage: "don't panic but if you are going to panic, panic first!" In crises, bank credit is re-priced driving up swap spreads. Higher credit spread volatility also forces dealers to hold additional capital increasing spreads.
In the current credit crunch, bank credit risk has deteriorated sharply as a result of losses on sub-prime (currently around $70 billion plus and still counting). There is palpable fear of a bank defaulting in the money markets. The very wide spreads in the credit default swap market currently are testimony to this fear.
A large volume of assets - somewhere between $1 and 2 trillion - held in off balance sheet vehicles such as collateralized debt obligations ("CDOs"), asset backed security commercial paper ("ABS CP") conduits and Structured Investment Vehicles ("SIVs") are likely to return onto bank balance sheets. A known unknown is the further amount of securities held as collateral for loans to hedge funds that may come back onto bank balance sheets. This re-intermediation is forcing banks to raise substantial volumes of term debt placing additional upward pressure on bank credit spreads. Banks have also been hoarding cash in anticipation of higher funding needs.
Investors have sought "safe harbors" buying government bonds driving down Treasury rates, especially at the short end of the Treasury curve. Repo rates, closely tied to Fed funds and discount rates, have fallen. Credit spread volatility is very high forcing dealers to hedge.
All this means that inter-bank rates (LIBOR and Euro-IBOR) have stayed high while government bond rates have fallen sharply. This has increased swap spreads.
Swap spreads will continue to be under pressure and remain volatile until the underlying credit risk conditions change. Swap spreads will likely rise further as the problems continue – levels reached during the LTCM/Russian crisis are not behind the realms of possibility. Given the high level of leverage in credit markets this time around, any further rise in swap spreads is not welcome news.
Regulators and central banks have few policy tools to directly influence the market driven swap spread. Cuts in central bank rates and pumping liquidity via money market operations into the system has little if any impact on the swap spread. It is only change in overall credit conditions and especially bank credit risk that will affect the swap spread. It is difficult to see the current initiatives of central banks doing this.
The TED spread has a parallel in commodity markets – the "Dead spread". This is the spread between live hogs and pork belly future contracts. At present, bank traders like the unfortunate pigs are getting killed as their funding costs continue to spiral upwards.
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