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Thread: weekend commentary ... why the LIBOR matters to Americans

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    Banned Melonie's Avatar
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    Default weekend commentary ... why the LIBOR matters to Americans

    1. Why Should You Care About LIBOR?

    Overnight the three-month dollar LIBOR rose 4 basis points to 4.95% today, the biggest one-day increase since Sept. 3, according to the British Bankers' Association. But what is LIBOR, and why should you care?

    * LIBOR is the London Interbank Offered Rate for dollars.

    * Simply put, it's the amount banks charge each other for loans.

    * Ok, so why do we in the U.S. care about the London Interbank Offered Rate?
    * A number of important reasons.

    1) LIBOR is the most active interest rate market in the world.
    2) It is the reference rate for many financial derivatives.
    3) It is an important benchmark for determining "real" supply and demand for credit.

    * Another way of viewing LIBOR is to consider it as a "real" indicator of supply and demand.
    * Why "real"?
    * Because LIBOR, which generally trades only a hair of a percentage point (we're talking a few hundredths) above the Federal Funds rate [a.k.a. the TED Spread - sic], is the overnight lending rate among banks set outside the U.S. Federal Reserve's control.

    * The Federal Reserve has many tools at its disposal to set the Federal Funds rate, the overnight rate charged by banks, but has no control over LIBOR.

    * The fact that LIBOR is high and rapidly rising is an indication that either demand for dollars by large banks is high, or supply is low.

    * In this case, demand is high because banks are both hoarding cash to ensure they have adequate reserves, fearful of more writedowns [a.k.a. losses on mortgage paper and derivatives - sic], and supply is low because they are afraid to lend the money to other banks, fearful they won't be repaid.

    * That's why LIBOR matters to you.
    Last edited by Melonie; 12-01-2007 at 06:10 PM.

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    God/dess Deogol's Avatar
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    Default Re: weekend commentary ... why the LIBOR matters to Americans

    I guess we can pretty much count on a fed rate cut in the future then if there are not enough dollars out there as it is.

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    Banned Melonie's Avatar
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    Default Re: weekend commentary ... why the LIBOR matters to Americans

    ^^^ actually, what you can probably count on is not that the Fed will cut interest rates again (which would only increase the TED spread between LIBOR and Fed Funds - but they'll probably cut the Fed Funds rate anyhow to forestall some 'subprime' mortgage defaults), but that the Fed will put the printing presses into hyperdrive. In the past this usually resulted in this 'new money' going straight to the investment banks, and from there into the US stock market and thus to the private sector economy. However, the big unknown is this recent 'flight to safety' trend i.e. investors turning to US gov't bonds in search of safe and secure returns on their money given some real or perceived element of fear regarding the actual financial state of some big private sector banks.

    Putting some numbers to this, if tax exempt super safe gov't bonds are available which pay 3%, and if the Fed lowers interest rates such that private sector bank CD's wind up paying a taxable 4.5% (again) instead of 6%, why would any rational investor choose to give their money to the private sector bank instead of the gov't agency behind the gov't bond ? And given a 10% reserve requirement, for every $1000 that investors decide to park in a gov't bond instead of a private sector bank CD, that's $10,000 worth of new loans that the private sector bank will be unable to write !

    If the Fed prints 'new money' and it winds up circling right back into the purchase of more US gov't bonds, in point of fact none of the 'new money' is actually being added to the private sector economy. In fact, the Fed cutting interest rates will arguably exacerbate this 'flight to safety' trend, since it reduces the differential between interest rates paid on private sector investments versus interest rates paid on gov't bonds (or viewed inside out, it reduces the 'cost of safety' i.e. the lower rate of return available on super safe gov't bonds versus the higher rate of return available from private sector bank CD's / stock shares / corporate bonds).

    This phenomena has sometimes been referred to as 'pushing on a string' i.e. the gov't can print 'new money' till the proverbial cows come home but they can't force that 'new money' to go where the gov't would like it to go.



    (snip)" Pushing on a String - the LIBOR Conundrum

    And that is a major concern, as there is a large disconnect in the market. Notice in the graph below how close a connection there is between the two-year Treasury note and 30-day LIBOR rates [a.k.a. the TED spread again - sic].

    That is, until recently, as two-year rates have plunged to 3.01% and LIBOR has risen to the above noted 5.34%. This is a major fire alarm, telling us there is something wrong in the building. And what is wrong is that banks are in trouble. And we are not talking just US banks, we are talking about banks all over the world. They are having to bring SIVs and other products onto their books, make provisions for larger losses, and so on. But as Greg points out, the growth in "assets" that came from deposits was only about 10% of the total growth, meaning the rest is loans outstanding.

    Where are they getting their capital? Buried in the text of the FDIC report, Greg found this line: "Insured institutions increased their reliance on wholesale funding sources." They are having to borrow money at a much higher level than normal, sending rates up.


    The structured security market is in a freeze, which is the funding source for much of the credit in the US and the world for such everyday things as car loans, credit cards, student loans, commercial bank loans, commercial mortgages, and construction. The CLO (mostly bank loans) market is reeling. There is no effective subprime mortgage market. Now, maybe the world settles down after the holidays. But right now, there is nothing to suggest that.

    Indeed, Greenspan warned in 2005 of exactly the scenario we are seeing today. He was talking about the rise in housing prices and other assets, and then concluded (emphasis mine):

    "Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

    So, even as the Fed cuts rate, the cost of financing and credit is going up. The odds for a 50-basis-point cut at the next meeting are rising with the arrival of each new fire truck."(snip)

    (snip)" The Fed needs to act preemptively, and the sooner the better. Remember Greenspan's speech a few years ago, in which he opined that the Fed needed to focus on avoiding the truly dangerous long-term situations rather than smaller near-term problems? The truly dangerous problem is a credit crunch. Lower rates in a credit crunch will be like pushing on a string. Think about Japan in the '90s. Even zero rates did not help.

    This current credit crunch has the potential for growing into a full-blown credit crisis, the likes of which we have not seen in the modern world. It is not altogether clear that cutting rates at 25 basis points per meeting is going to do anything to help, if the cost of borrowing does not come down. We are in an entirely different type of crisis than we have ever seen.
    It is not for certain that the old tools, the fire sprinklers, if you will, will be enough. We may need to adapt to a new, interconnected world.

    The real problem is not one of credit or even liquidity, but of confidence in the assets you are purchasing. If you cannot trust an AAA-rated piece of paper in a state-run money market fund, you get very concerned about where to put your money. Until the markets start offering investment products with full transparency and real guarantees for the higher-rated tranches, it is going to be difficult to restart the asset-backed security markets.

    (And with credit insurers being threatened with a drop in their credit ratings due to inadequate capitalization for the mortgage guarantees they provided, even insurance is no longer seen as a solid back-up.
    That is a major fire truck parking next to the building, but one that is being ignored. Talk about a threat to the entire system.)

    One encouraging thing to note is that large hedge funds are stepping in to provide liquidity and loans where banks and the usual markets cannot. Of course, they do this at a price. Abu Dhabi got 11% for its money for bailing out Citi, although they did agree to convert their debt into stock at higher prices than the current market price. But 11% for a few years guarantees them a total investment at what they must have considered an attractive rate."(snip)


    The bottom line of all this is that the Fed continuing to cut rates may already be at the point of becoming counterproductive. Fed rate cuts do absolutely nothing to reduce the high cost of 'borrowed working capital' that the banks must obtain to remain solvent in the absence of US savers / depositors giving banks their money to work with instead. Keep in mind that for the past several years Americans have had a NEGATIVE savings rate, and have been 'rolling over' loans instead of paying them off in full, both of which sapped capital away from banks !!! Thus the banks were already ill prepared for a situation where they are now forced to divert what remaining capital they have into loan loss reserves to cover 'subprime' mortgage losses, mortgage based derivatives losses etc.

    This in turn will lead to very low interest rates being paid to bank savers / investors (despite the risk they are taking in allowing a 'shaky' bank to use their money), while at the same time very high interest rates will be charged of new borrowers (to compensate the banks for their cost of 'borrowed working capital' i.e. Abu Dhabi's 11%). Ths formula is guaranteed to result in an economic slowdown at the very least.
    ~
    Last edited by Melonie; 12-01-2007 at 09:52 PM.

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