Friday, April 18, 2008

Rise Lord LIBOR!!

(Accrued Interest) When trying to gauge the market's generalized view of counter-party risk, swap spreads are a good place to start. This is the spread between Treasury securities and the fixed leg of a plain-vanilla interest rate swap. Since there is necessarily some bank or brokerage as the counter-party of such a swap, the spread is a good indication of counter-party risk.

So it comes as little surprise that swap spreads have been elevated in recent months. 2-year swap spreads averaged 40bps during the first half of 2007, recently spiked above 100bps just before the Bear Stearns collapse. Afterwards, it declined into a more stable trading range in the low 80's.

But in the last week, spreads appear to be spiking again, having risen 13bps in the last three trading days, from 83 to 96bps on Thursday, and briefly crossing +100bps. (On the chart, Libor is in orange and 2-year swaps in white).



Is it a return of the liquidity crunch? Its a bit of a conundrum, because most other indicators have been pointing the other way. The VIX has declined over 3 points in the this week. The CDX indices are significantly tighter: investment grade -19bps this week and high yield -56bps. Bank and brokerage CDS are also markedly tighter. Wachovia and Citigroup are both about 25bps tighter, Lehman, Merrill, and Morgan Stanley are all at least 30bps tighter.

Perhaps the answer lies in some wishful thinking on the part of European banks. According to the Wall Street Journal, official Libor fixings have not reflected the real cost of intra-bank borrowing. 3-month Libor, for example, was fixed at 2.73% on Wednesday, but I have been hearing actual bank lending is happening at levels more like 3%. This had lead some to question whether the banks that help set Libor are being entirely honest about the levels being supplied.

This morning, 3-month Libor was fixed at 2.91%, suggesting that maybe these banks are starting to fess up.

I'm not going to comment on potential manipulation, since I'm in no position to speculate on such a thing. But Libor has been rising lately. After falling to 2.54% on March 18, the same day the Fed cut its target rate by 75bps, Libor has steadily risen to this moring's level of 2.91%. That obviously has an impact on swap spreads.



Since 3-month Libor is the floating side of a plain-vanilla swap, and Libor has been rising, it follows that the fixed side must rise as well. That explains why swap spreads are moving. But its doesn't explain why Libor itself has been rising, especially if it really should be even higher. How to reconcile the lack of liquidity implied by rising Libor with otherwise tighter credit spreads?

I think this signals a shift in the credit cycle. Until now the focus has been primarily on structured products: SIV, CDO, ABS, etc. Those are primarily the domain of the large financial institutions. I.e., the names that trade in CDS routinely, that get reported on CNBC every day, and by the way, the same names that have been taking all the write downs. The Lehman's and Citi's and Merrill's.

Maybe tighter CDS spreads in these names is indicating that those institutions have taken (or reserved for) most of the losses they are likely to take. But what about smaller banks? The regional and local banks that may never have been involved in a CDO, but might also have a lot more risk in a single borrower or category of borrowers. Perhaps 2.90% is in the right ballpark for Lloyds Bank, who is part of the Libor survey, but not for the local bank in Norwich.

And what about Europe in general? Libor is set by a survey of 16 banks, only two of which are American. It has long been said that Libor is really a indication of where European banks can borrow in U.S. dollars. So rising Libor may say more about tight liquidity in Europe than in the U.S. A combination of tough liquidity in Europe and among smaller banks would explain the divergence between CDS spreads and Libor spreads.

To me, this sends two cautions. First, it should remind anyone who thinks the liquidity crunch is over, that it ain't. Liquidity does seem to be improving in the U.S. bond market, which is a very positive sign. So maybe the worst case scenario has been taken out. But this will be a long process.

Second, it should caution those who are short the dollar. If the next phase of the credit crunch hits Europe as hard as it hits the U.S., then we may see the Bank of England and the European Central Bank get more aggressive with rate cuts. Indeed today there are stories that the BoE is working on a plan to inject more liquidity into the banking system. That would ease pressure on the dollar. Given how popular short dollar trades have been, any reversal may be violent.

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