What price, risk?
If you’re a bank, for the past few weeks you haven’t really needed Libor to come down in order to ease your acute liquidity needs, given that there has been a government backstop in place for more or less all of your short-term financing ops.
And of course, Libor isn’t of course based on actual transactions per se - it’s merely an educated estimation of what such transactions are costing. Largely a hypothetical one at that, since banks are still not curing short term funding needs by lending to each other in a strict interbank sense, but rather predominantly through accessing commercial paper markets or else using the Fed’s rolling liquiditypalooza in some form or another.
With that in mind, there’s in fact every incentive to keep Libor up given that most of your business - loaning - will be being conducted against Libor as a base rate.
The fall in Libor then that we are witnessing, is actually a bad thing for banks.
Consider: the rise in Libor reflected a systemic crisis in the banking system — a crisis that is also manifesting itself in the broader economy, which will likely enter a severe recession. The fall in Libor naturally reflects the decline of fears about banking collapse, but it doesn’t - can’t - capture the still existent fears at banks about the broader crisis.
Banks then, are looking to tie their lending to corporations to other measures, which still capture the fraught situation facing their corporate borrowers.
From Bloomberg (Via Mish):
Oct. 29 (Bloomberg) — Citigroup Inc. and Credit Suisse Group AG are among banks tying corporate loan rates to credit- default swaps, raising borrowing costs and exposing companies to derivatives accused of crippling the financial system.
Nestle SA, the biggest food producer, Nokia Oyj, the largest mobile-phone maker, FirstEnergy Corp., the Ohio-based owner of electric utilities, and at least three other companies bowed to banks’ demands to link the interest rate on credit lines to the swaps, which are used to bet on borrowers’ likelihood of default.
On the one hand, this seems to make perfect sense. High CDS spreads have been proven leading indicators of defaults in the past few months.
On the other hand, though, it’s a pretty clear signal banks have lost control.
_______
Banks are supposed to be arbitrary lenders, in the sense that they perform, in-house, the necessary due diligence on on the creditworthiness of a company, and lend to that company accordingly.
Tying rates to CDS, though, is effectively outsourcing opinions of the creditworthiness of a company to the market. Indeed, it’s more of the same “outsourced” due diligence from banks that in part inflated the ‘00-’07 debt bubble in the first place.
Tying lending to CDS spreads also creates something of a dangerous positive feedback loop. Consider: CDS spreads move up because of fears about a funding issue at a company; a funding issue which suddenly becomes real - or else greatly more pronounced - because the CDS spread has widened.
Of course, to some extent, this kind of loop already exists in the market. Dick Fuld would blame it for the fall of Lehman Brothers. There’s a difference between Fuld’s griping though, and this. The feedback loop which may have done Lehman in was not a direct connection: it took months of bad news; writedown after writedown; before a tipping point was finally reached for Lehman. The conductivity of that LEH feedback loop was extremely poor. In the case of lending tied to CDS though, the feedback loop would be direct; with an instantaneous impact on a companies balance sheet. (One which you could probably calculate, given knowledge of the debts’ terms).
____
So what price risk?
That’s a toughie to answer. Banks don’t - didn’t - know; but actually, neither necessarily does the market. Even if you’d always priced your lending over CDS spreads, you’d be no better off as a bank now than if you’d priced loans over Libor:
In fact, to look at this more broadly, the problem is precisely that banks have long been relying on the market to price risk, rather than assessing its fundamentals themselves. Such is the magic of securitisation. Pricing off CDS spreads then might not be such a departure from current practice. It’s just a more transparent way of doing what’s been going on all along.
