Tuesday, June 23, 2009

LIBOR is useless


Much has been made of Libor’s recent descent to post-Lehman crisis lows. But while some say it marks the return of a healthy interbank lending market, others — rising in number by the way– appear to see it as evidence of Libor’s growing irrelevance.

LIBOR-OIS spread - Bloomberg

Chief among the “Libor is useless ” brigade is Zerohedge blogger Tyler Durden. He writes in a recent post:

…in true pro-cyclical fashion, the expectation for permanent governmental crutches can be best seen in some of the same metrics that in the post-Lehman days markedly went off the charts, most notably the LIBOR rate. From record wides several months ago, LIBOR, which is critical as it is the reference risk rate for trillions in assorted product classes, has collapsed to an unprecedented low. The rate drop has manifested in an inversion of the 1 Yr UST - 1 Yr LIBOR spread, with the latter clearing 100 bps inside of the former: a topic covered in detail previously by reader Gary Jefferey.

He further points us to news that the British Bankers’ Association (BBA), which sets the daily rate, is looking to expand the list of banks contributing quotes to the daily fixing due to the mergerfication of its 16-standing members. As the WSJ notes:

Currently there is no good alternative to LIBOR, although the Overnight Index Swap (OIS) is trying to replace it with limited success. So, the marketplace is searching for an alternative with many banks attempting to devise their own measures to varying degrees of success.

They go on:

World central banks have used the Term Auction Facility (or TAF) in a heavy-handed way to suppress LIBOR. They are doing this because virtually all subprime adjustable rate mortgages (ARMs) are reset using LIBOR. In other words, world central banks are subsidizing shaky mortgages by artificially lowering the reference rate used to reset rates every year. The problem is banks are not happy with the effect this has on other lending and are looking for alternatives. So in a nutshell, yes, central banks have successfully driven down Libor rates thanks to the Fed’s TAF facility. This is good because most subprime adjustable rates are linked to Libor. Great joy. However, as far as encouraging banks to lend again, that might be an entirely different story.

Banks are seeking out alternatives to low Libor rate because they’re clearly still unconvinced by talk of an imminent recovery. They still want to protect new lending with deals linked to alternative rates, more reflective in their minds of the premium needed to cover their risk exposure.

The BBA’s move, meanwhile, is a case of adapt or die. The manoeuvre clearly hopes to prove Libor is still relevant to the market, but actually shows off more concerns about its use as a floating-rate benchmark in the future than anything else.

In which case, while low Libor rates might be a good indicator for prospective default rates, as far as indicating a return to normal interbank lending practices, they may be very misleading. In this respect it’s perhaps better to look at issuance of commercial paper - the lifeline of business financing, which certainly isn’t as optimistic. For one, note the following chart from the the St. Louis Fed showing current commercial paper outstanding to nonfinancial companies in the US:

Commercial paper - St. Louis Fed

As can be seen, there’s hardly been any pick-up in issuance since the post-Lehman phase of the crisis took hold — this despite the epic fall of Libor. Lending to business remains - in no uncertain terms - firmly crunched.

As the Pragmatic Capitalist noted last week:

The deceleration in commercial paper has had a very high correlation with economic activity in the last two years. The recent cliff dive in commercial paper represents how weak near-term business activity has been across the economy. I would expect to see a substantial acceleration in the ABCP market before we see any sharp acceleration in economic activity. As of now, the commercial paper market is nothing more than a sure sign that the so called “recovery” is beyond weak and is perhaps even weaker than many “green shoot” theorists assume. A double dip recession is looking more and more possible as we move into the second half of the year…

No comments: