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A Note About LIBOR

What It's NOT Telling Us About the Credit Situation

By: Francis Cianfrocca (Diary)  |  October 2nd, 2008 at 10:25 AM  | 

RESIZE: AAA

Several of our conservative friends have pointed to the very large reduction in the LIBOR interest rate between Tuesday and yesterday as evidence that the credit crisis is easing.

LIBOR is one those arcane things no one but geeks should need to understand. It’s a notional interest rate published at 11:00 AM GMT every day in London. It represents an adjusted average of the “offers” of sixteen large London banks for various kinds of short-term loans.

The offer is the rate at which the banks are willing to lend money. (The “bid” is the rate at which a borrower is willing to borrow. The market is generally somewhere in between the bid and the offer.)

LIBOR is extremely important for reasons I won’t get into now. But the dollar-denominated LIBOR rates (overnight and three-month) are key indicators to the health of the credit markets.

On Tuesday, LIBOR (which ought to be below 2.5%, given that the Fed funds target rate is 2%) shot up to nearly 7%, from about 3.8% on Monday.

And it fell just as precipitously on Wednesday, back below 4%.

This is being taken by some as a sign that credit markets are unfreezing. But that’s not the case.

Tuesday was the last day of the third quarter. Demand for short-term cash is always unusually high at quarter-end, because banks need to close their books and square their positions. The Tuesday rate was a technical distortion.

If you take Tuesday out, dollar LIBOR has been marching steadily upward all week. Overnight dollar LIBOR dropped sharply to about 2.85% this morning (if memory serves), but this reflects enormous injections of central-bank liquidity more than actual market conditions.

Three-month dollar LIBOR is still far above normal, and that’s a better indication of the sickness of credit markets, as it relates to actual business activity in the real economy. We have NOT yet had a break in the tension.

-Francis Cianfrocca

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COMMENTS

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  • streetwise

    Three month Libor, currently at 4.21%, was 2.81% at the beginning of September.

    During better economic times, Libor is higher- it was over 5% a year ago. But that is normal. When the economy is humming, there’s a greater demand for money and increased concern about inflation, so rates rise.

    When it is stalling (and some would say it is tanking), a sharp, sudden increase in short rates is signalling a big problem.

    You can get more info re Libor from
    the British Bankers Association

  • markreiboldt

    It is important for policymakers and the general public to keep in mind that since we’re facing a long-term crisis with volatility and uncertainty at max capacity, any attempt to show correlation between variables related to the credit markets will likely by highly heteroskedastic. Meaning, trying to use short-term volatility in LIBOR as an indication of the overlying crisis is not only presumptive but econometrically inefficient. Moreover, LIBOR doesn’t change based on exogenous factors alone like Congressional legislation, not even the bailout. There are too many other variables – this would by like trying to form conclusions about LIBOR and the credit markets in a vaccume. Either way, with uncertainty so high, any attempts at correlation would be highly suspect.

    • blackhedd

      Now they’re at 2%. It was a different kind of aberration that LIBOR was below the funds rate. But you worry a lot less about that.

      • markreiboldt

        what’s have the pertinent moving averages been? That’ll say more about the short-term volatility.

        • Dave_in_Fla

          Wow, there is a new word for me. And that doesn’t happen often. :tips hat:

          • streetwise

            they smooth out the volatility.

            But if you’re a corporate borrower, all that matters is the rates on the dates you borrow.

            If you’re a bank, and borrow every day to fund yourself, the pain of a sudden rate rise is felt very quickly.

          • streetwise
          • streetwise

            To hell with principle!

          • wsjreader

            actually you’re not exactly right. Most commercial loans to corporations are based on floating rates. The borrowing rates are generally based on LIBOR plus a markup. So it does matter to lots of companies.

          • streetwise

            But many corp loans reset every three or six months based on Libor two days before the reset loan.

            so if you had a loan that reset on Aug 31, you got a much lower rate than what you got today, oct 2.

          • markreiboldt

            butcher the legislation, it also eliminated the controls for homoskedasticity

  • quill67

    OK. I know this is a radical step, but at least for X number of days couldn’t we guarantee (Congress, maybe Fed with creativeness) any commercial paper written to businesses with a certain credit rating??

    I know this might be overutilized but wouldn’t that be a good thing at this time?

    • speciallist

      n/p

  • Spartan4Life

    I know the data was ugly today but I thought part of the idea here was to supply some confidence to shaky markets. If that was really going to happen, I would have thought the vote in the Senate would have given the markets a little lift. I am getting concerned that this might not work.

    • markreiboldt

      is still through the roof, mainly with the focus on whether or not the House will pass the bailout. Also, while the big hit on Tues was in response to the failed vote, you’re now starting to see results of actual data (i.e., unemployment, GDP, etc) affecting the markets. And most importantly, there’s still a major insolvency problem and a perception of illiquidity in the credit markets (even though hundreds of billions of dollars have been pumped in the last few days). Simply put, the markets are unsure

  • Samsara

    I saw the article over at Human Events Magazine by Jed Babin. It is garbage. He takes one quote from the Financial Times, twists it out of context, and draws a conclusion totally at odds with the article and the facts. Poorly researched, pseudo-conservative drivel like this does not serve anyone’s interest.

    Clear explanations of financial matters like Blackhead is providing are a breath of fresh air.