Thursday, March 25, 2010

Libor-gazing, counterparty-casing

Original posted on FT Alphaville by Tracy Alloway:

Does anyone remember Libor?

The London Interbank Offered Rate, the reported cost of borrowing between banks, has fallen by the wayside a bit since it shot to infamy — and a record high — in October 2008, in the wake of Lehman’s collapse. But with recent negativity in swap spreads, Libor is being thrust back into the spotlight.

The key measure for Libor is the Libor-OIS spread, or the difference between the interbank rate and the market’s expectation of central bank rates — i.e., pure counterparty risk.

Here’s a chart of what the (3-month dollar) spread’s been doing recently (click to enlarge):

The lows of the spread are important since they indicate the ’success’ of government actions. In September 2009, for instance, Libor-OIS reached 11bps, about the average rate pre-credit crisis — but that was with the huge supporting factor of government bank guarantees and liquidity programmes.

But you can see from the above chart (or alternatively from this one) that there’s been some volatility in the spread, with a recent uptick trend. Libor-OIS though is currently at about 8.3bps — well below its pre-crisis levels.

Where does this all fit with negative swap spreads?

Swap spreads are basically the difference between Treasuries and interest rate swaps. Swap rates are usually based on Libor, which means that under normal circumstances the spread is positive since lending to the US government is perceived as less risky than lending to a money market or bank counterparty.

But, the 10-year spread swap went negative on Tuesday. The 30-year spread went negative back in 2008, post the Lehman collapse, and has been confined to zero or sub-zero ever since.

Jck over at Alea puts it eloquently:

By construction swaps rates represent double AA credits , while government bonds represent the credit of the sovereign state. It has long been assumed that negative spreads are mathematically impossible, but this is true *only* if the sovereign is a real triple AAA, otherwise the spread can go negative. Since the swap rate is a hardwired double A, the message of negative swap spreads is that sovereigns aren’t or won’t be real triple A going forward. C’est tout.

While counterparty risk measured by Libor-OIS has reduced rapidly, it looks like the USA’s counterparty rating may be deteriorating in the eyes of some investors viz those negative swaps. Perhaps that’s to be expected with the central bank essentially taking on much of the market mantle.

(Others of course, think differently).

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