Wednesday, June 3, 2009

Fall in Libor fails to paint a true picture

Posted in the Financial Times by David Oakley and Michael Mackenzie:

Money market rates have fallen dramatically since peaking in October last year, helping to raise hopes that the credit crisis is easing.

The drop in these rates, known as London Interbank Offered Rates (Libor), signals a sharp improvement in market sentiment at a time when central bank interest rates are at historically low levels.

Low Libor rates, the amount banks charge each other to borrow short-term from overnight to a year, should stimulate lending in the financial markets and therefore boost economic growth. Three-month Libor rates are used to price $350,000bn in financial products worldwide.

Hence lower Libor rates should also reduce the cost of issuing billions of dollars of bonds, loans and structured products.

The cost to borrow dollars, euros and sterling over three months has fallen to 0.636 per cent, 1.265 per cent and 1.271 per cent respectively.

This compares with highs in October of 4.820 per cent to borrow in dollars, 5.393 per cent to borrow in euros and 6.285 per cent to borrow in sterling.

The so-called overnight index swap (OIS) spread between three-month Libor and risk free overnight market rates – a measure of credit risk – has also fallen in the main currencies to levels before Lehman Brothers collapsed in September.

However, analysts and bankers warn that Libor rates may not be telling the full story.

That is because there are wide differences between the rates at which individual banks can borrow. The biggest institutions are able to fund themselves at around Libor levels while smaller institutions have to pay, in some cases, more than 100 basis points above Libor. This is explained by continuing counterparty risk in what remains an uncertain economic environment.

That contrasts with the situation before the credit crisis when institutions paid similar rates to borrow.

Meyrick Chapman, fixed income strategist at UBS, says: “We should not build up our hopes that the fall in Libor is such a positive sign for the markets. We have a very tiered market, where many smaller banks are still having to pay relatively high rates to borrow.”

Lena Komileva, head of market economics at Tullett Prebon, adds: “What we are seeing is a huge difference in the price of borrowing for individual banks. There is a higher proportion of banks paying above Libor.”

The British Bankers’ Association, which sets Libor by compiling an average cost of lending from the 16 banks, defends the rate, stressing that the market understands it is a reference point for the strongest banks.

John Ewan, director at the BBA, says: “We use 16 banks to set the Libor rate. They are among the biggest banks in Europe. The market knows this and understands that other smaller banks may have to pay more. This is not a false signal to the markets.”

Some analysts also point out that a rate of 100bp above Libor is still very low on an historical basis. Libor rates are at record lows as they track central bank rates, which are close to zero in the US, 0.5 per cent in the UK and 1 per cent in the eurozone.

Central banks have helped the market, too, by providing vast amounts of liquidity in secured lending, where banks and institutions can raise money at low rates in exchange for collateral.

However, the higher rates the smaller institutions have to pay in the unsecured lending markets, which were the most flexible and easiest to access before the credit crisis, will slow recovery as the higher costs will act as a drag on their earnings and mean institutions will take longer to recapitalise. Institutions also face difficulties funding much further out than three months as banks are reluctant to lend beyond this period due to counterparty risks. And when they do so, it is at punitive rates.

At the same time, funding in the longer-term corporate bond markets is very expensive.

The bond markets, where bond funds and asset managers are the main lenders rather than the banks, may be open with issuance at record levels, but the costs for an investment grade company is nearly 200 basis points more than it was at the start of 2008.

The average rate for a triple-B rated company to issue bonds in dollars is 7.75 per cent compared with 5.92 per cent in January 2008, according to Merrill Lynch.

That forces many institutions to roll over their debt in the short-term markets, where maturities are typically no more than a month.

Significantly, this type of funding is likely to become more expensive as most analysts expect Libor rates to rise with official central bank rates unlikely to fall much lower.

Steven Major, head of global fixed income at HSBC, says: “Libor is very misleading. The published levels may be very low compared with recent history, but in reality I am not convinced much volume is going through beyond the one-month maturity. Furthermore, if institutions want to fix their debt over a longer term they have to pay enormous rates to do so.”

Gary Jenkins, head of fixed income research at Evolution, agrees: “The fall in Libor rates is not a great guide to what is happening in the overall economy. We are definitely in for a long haul. We won’t get back to a situation where banks are lending in the way they were before the credit crisis for a long, long time.”

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