Better TED than Dead! – The Tale of Inter-Bank Rates

By: Satyajit Das

 

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 credit crunch, the behaviour of inter-bank rates is proving deadly to a new generation of traders.

 

The difference between inter-bank rates (LIBOR or the London Inter-bank Offered Rate or it equivalent in other currencies) and central bank rates or government bond rates has increased sharply. This is making inter-bank and corporate borrowings expensive 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 basis points per annum to around 60/70 bps. During the 1998 Russian/ LTCM episode swap spreads peaked at well North of 100 basis points per annum.

 

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 force 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 US$ 100 billion plus and still counting). There is palpable fear of a bank defaulting in the money markets reflected in the very wide spreads in the credit default swap market currently are testimony to this fear.

 

Investors have sought "safe harbours" 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.

 

The beginning of 2008 brought some relief for banks. TED or swaps spread fell as the difference between inter-bank rates and official targeted central bank money market rates declined. In mid January the spread actually went negative - the overnight rate US$ LIBOR ("London interbank offered rate") closed below the Fed Funds target rate. The 3 month US$ LIBOR for dollars also fell sharply - by around 20 basis points to 4.06%. This was its biggest fall since 19 Sep 2007 when the Federal Reserve Open Market Committee’s cut the Fed Funds rate by 0.50%.

 

The decline in the spread was technical. Fears of a recession mean that the money markets expected a sharp cut in US official rates. The inter-bank rates were merely anticipating the cut. When Fed Funds rates were cut (by 0.75% pa) then the TED spread became positive.

 

Swap spreads will continue to be under pressure and remain volatile until the underlying credit risk conditions in the bank market change.

The outlook for bank credit remains uncertain. Major global banks will record significantly lower profits and in some cases losses in 2007.

 

A large volume of assets - somewhere between US$ 1 and 2 trillion - held in off balance sheet vehicles such as collateralised 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.

 

Bank capital positions have been sharply impaired. Recapitalisation of the banks is heavily dependent upon the investment appetite of sovereign wealth funds and banks in Asia and the Middle East. Given the size of the requirement and the frequent trips, this well is at risk of running dry.

 

The quality of the banks credit portfolios remains questionable. In 2007, the banks losses were related to large mark-to-market changes in the value of structured securities (mortgage backed securities and CDOs) and leveraged loans. There were few actual defaults.

 

As the economy slows and borrowers need to refinance, actual losses may occur. Lenders to non-investment grade companies and private equity transaction look vulnerable. Consumer lenders have already reported slowdowns in consumer spending and increase in write-offs. Automobile loan delinquencies are also rising. Also if the mortgage rate freeze plan does not have the intended effect, mortgage losses in the US may also increase beyond anticipated levels.

 

Financial institutions also face a subdued profit outlook. Key areas of recent profitability (mortgages, securitisation and structured credit) are not likely to return to previous levels for some time. Corporate finance and mergers and acquisition revenues are slowing. Strong trading revenues will slow as risk appetite and capital available for risk taking reduces.

 

It is unlikely that the credit quality of the banking system will rebound drastically. Certainly, the current share prices and credit default swap ("CDS") spread are not optimistic - in January 2008, a ‘A’ rated industrial company was able to issue bonds at a spread below that of a ‘AA’ rated major bank.

 

An additional complication will be the CDS market itself. Banks have used this market to lay off risk. There are significant documentary complexities – some untested. The efficacy of the CDS will depend on the quality of the counterparty to which risk has been transferred. If actual defaults occur and the CDS market does not function then uncertainty about who is holding which risk and concerns about bank credit quality may re-emerge.

 

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.

 

The current initiatives of central banks have minimal effect on the spread. In fact, they may make the position worse. If the central banks withdraw the emergency liquidity as the European Central Banks ("ECB") intends then money market liquidity condition will tighten. If the central banks continue to supply liquidity then they may set of inflationary expectations causing longer-term rates to increase sharply. This may be their strategy in any case.

 

The current spread in US$ between the 2-year and 10 year Treasury is around 150 basis points. In 2003 after the Fed cuts short-term rates to 1.00%, the spread went to 275 basis points. Traders currently expect the 2/10 spread to hit 250 basis points. Higher long-term rates will affect the cost of mortgage debt and term borrowings. This will not help the housing market and may in turn lead to higher defaults.

 

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.

 

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.

 

© 2008 Satyajit Das

---