LIBOR and the seeds of the recession

October 6, 2008

 

The British Bankers’ association’s London Interbank Offered Rate (LIBOR), the rate at which banks loan money to each other, is a good indication of how risky is the world is seen to leading banks. In the case of the US dollar rate, there sixteen banks on the panel that determines the LIBOR (see here for a great description of how LIBOR is determined

The LIBOR is the beating heart of the interbank system, and reacts instantly to new information. However, it also shows how risk perceptions, and following these, a potential recession, come about.

The LIBOR rates for the first 29 days of September show this vividly. The line marked O/N (you can disregard the S/N as the graph is for USD) is the overnight rate at which banks are ready to loan money to each other – the shortest period of loan. The jump on 16th of September to the 18th indicates the flight to look at the jittery. The longer periods follow suit (1 week, 2 week, etc), as can be seen, but more moderately. The jump is dramatic, of course, but more ominous is the longer-term change that the graph reveals. First, LIBOR rates have moved up from about 2.5% to almost 4%. This indicates the higher degree of risk assigned to loans. This on its own is important, but even more telling is the spread of rates across the different periods. While on 1st of September, the range between the lowest and the highest rate was 0.8%, (not taking into account the very volatile overnight rate), the range on 29th of September is only 0.09%! This shows that not only that banks see their environment as riskier than before, but they also distinguish less between more and less risky loans. In fact, they tend to see all loans, regardless of the period for which they were taken, as risky. Such, diminished distinction is a sure sign of flight to liquidity – institutional risk avoidance, but it is also a reflection, if it continues, of a slowdown in macroeconomic activity. If all loans are seen as high risk, less loans are going to be granted.

10 Responses to “LIBOR and the seeds of the recession”

  1. danielbeunza Says:

    This is useful. But here’s an indicator that is –I think–even more useful. The so-called “TED spread” measures the gap between the LIBOR rate, which you mentioned, and US Treasury Bills.

    http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND

    Treasury bills measure the genuine preference for liquidity. By “deleting” the Treasury Bill component, the TED spread measures the confidence that investors place on banks. If you want to see whether investor see calm or trouble ahead, all you have to do is check.

    Furthermore, the TED spread is an example of the power of spreads. Like the merger arbitrageurs that I studied in my ethnography, professional investors typically often think in terms of spreads rather than absolute magnitudes. The reason is that the interpretation is less noisy…

  2. danielbeunza Says:

    This is useful. But here’s an indicator that is –I think–even more useful. The so-called “TED spread” measures the gap between the LIBOR rate, which you mentioned, and US Treasury Bills.

    http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND

    Treasury bills measure the genuine preference for liquidity. By “deleting” the Treasury Bill component, the TED spread measures the confidence that investors place on banks. If you want to see whether investor see calm or trouble ahead, all you have to do is check.

    Furthermore, the TED spread is an example of the power of spreads. Like the merger arbitrageurs that I studied in my ethnography, professional investors typically often think in terms of spreads rather than absolute magnitudes. The reason is that the interpretation is less noisy…

  3. tmsiva Says:

    Yuval and David:

    LIBOR – OIS is now considered a better spread. Overnight Index Swaps are a “purer” bet on Fed Funds rates because there is no collateral involved, just a fixed/floating swap on a notional amount, so there are no worries about repo financing problems and flights to quality effects.

    I think MacKenzie is a little off-target in his LRB article in suggesting that EONIA is a bad idea *because* it’s just overnight. Euro OISs are priced off averages of EONIA over the relevant term.

    Isn’t a flat curve to be expected when rate-cuts are imminent and a recession possible? What does it look like now?

  4. danielbeunza Says:

    tmsiva – I dont have a problem with TED spreads vs. alternative spreads. my point was rather to illustrate the effectiveness of spreads. As for MacKenzie’s article… I’m surprised by your comment. Is it the overall argument you disagree with, or just a technical choice of indicator?

  5. danielbeunza Says:

    tmsiva – I dont have a problem with TED spreads vs. alternative spreads. my point was rather to illustrate the effectiveness of spreads. As for MacKenzie’s article… I’m surprised by your comment. Is it the overall argument you disagree with, or just a technical choice of indicator?

  6. tmsiva Says:

    Thinking in terms of spreads is always more useful if (and only if) that’s what the relevant market makers use themselves. That’s certainly the case here. A sense of how LIBOR-OIS changed over the coordinated rate cut would likely buttress Yuval’s argument that LIBOR was, and maybe still is, dysfunctional.

    I really liked MacKenzie’s essay. I wouldn’t have minded if he had been a little less exoticizing about LIBOR dealers (perhaps a simple comment about how even the dealers from posh schools/suburbs deliberately adopt East End accents would have balanced things out a little). More importantly, I think he was overly dismissive of the advantages of reported prices over observed prices. Reported prices can be manipulated too, as he himself says, and “banging the close” is allegedly a manageable problem in virtually every other market in the world. Why not in LIBOR?

    Finally, for exactly the reasons you gave, a mention of LIBOR spreads (and LIBOR curves) wouldn’t have gone amiss. Apparently, LIBOR-OIS went into six sigma territory around the time the article was published, so that would have been an ideal entry into a discussion of normal distributions assumptions…

    I guess I hold MacKenzie to very high standards!

  7. panik Says:

    Straying of Yuval’s initial posting slightly, but the way I view MacKenzie’s LRB article is as a part of the work he describes in a recent Economy & Society article [http://www.ingentaconnect.com/content/routledg/reso/2007/00000036/00000003/art00002] about the more general issue of the “material production of virtulity” that he explores through the case of derivatives, but that could apply to all sorts of other settings (e.g. computer games, virtual worlds etc). The imortance of LIBOR in that analysis relates to the concept of “facticity” that MacKenzie develops there and does not have much to do with better or worse ways of measuring or representing anything. It is more to do with the key role LIBOR plays as a crucial link in the chain of reference from the real economy and actual underlying assets to the metaworlds of derivatives because it is both factual but also constructed.

  8. tmsiva Says:

    Panik: I couldn’t agree with you more about the E&S article, except that I might modify your last sentence so that it reads “it is factual because well constructed” or some such Latourian turn of phrase.

    MacKenzie attention to delivery and settlement problems is entirely to the point. Would it be too much to say simply that exchanges make better facts than OTC markets, even ones with such careful reporting systems? Soros and a whole bunch of folks have been saying this for a while, at any rate.

    Intuitively (read “I have no evidence”) I’d say that LIBOR is in trouble as a measure because of the wide variety of ways that virtually anyone can get funding directly from central banks (in the US, first the Term Auction Facilities, and now under the bailout plan’s immense leeway, not to mention backing the Commercial Paper market first indirectly and now directly).

    The more these funding mechanisms are used, the expensive it is to borrow at LIBOR, and therefore the more trouble there is in LIBOR denominated markets, ie. mortgages.

    Siva

  9. tmsiva Says:

    The last paragraph should have also said that the banks that /do/ have capital have a reason for not lending at LIBOR. It’s in their interest to hold off loaning at LIBOR in order to drive down mortgage-based assets.

    Maybe there’s too much conspiracy theory here…

  10. panik Says:

    Siva, I see the point you are making and like the turn of phrase that you come up with, but still think that there is a reason that MacKenzie finds in necesary to put effort into bulding this notion of “facticity” rather than use the less arduous off-the-shelf option of “socialy constructed”.


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