Libor is back.
The FT reported on Monday that we are due a sharp rise in dollar interbank offered rates, on account of renewed credit risk fears around European banks.
Ah, but will it be a spike — or is this the New Normal breaking through?
According to Citigroup’s Neela Gollapudi, if Libor is set to jump, it will be in response first of all to the end of the too-big-to-fail era in US banking, now that finance reform has passed.
Senator Dodd was also quoted in the press as having said that the proposed bill “would significantly tighten up language in the bill dealing with the Federal Reserve’s ability to provide liquidity to the financial system in times of severe market distress,” and that “it requires the approval of the Treasury secretary before the Federal Reserve can undertake any emergency lending.”
What all of this means is that the nature of assumed government support to the large banks, will become more narrowly interpreted to mean only support for FDIC insured deposits. All other creditors will need to figure out where they stand in the queue in the event of failure at a large firm. This should cause a significant amount of thinking and reassessment at the various lenders to banks (money market funds, other banks etc.), especially about due-diligence, as well as the right price for short-dated credit risk.
Not just US banks, though. European institutions which have been implicitly backed by the state may not actually be able to count on it, now that the fiscal crisis is upon governments.
Together, this changes the Libor outlook quite a bit:
All this argues for unsecured dollar funding among large international banks to be at least 25-30bp higher than historical levels relative to the risk free rate than what it is now. Since 1997 the spread between financial CP at AA-rated and T-Bill yields has averaged about 36bp, with a median of about 31bp. If this spread needs to be about 25bp higher in the steady state before accounting for current European credit issues, we should see Libor at about 70bp (~=30bp + 25bp + current 15bp 3m T-Bill yield).
Clearly, US finance reform won’t be repealed any time soon — and neither will the fiscal weight dragging down Europe.
It’s interesting that Gollapudi also tries to factor in banks’ exposure to possible future writedowns in Europe’s sovereign debt crisis – for example, 15 to 25 per cent haircuts on government bonds, with lower rates for private defaults.
And this would further alter the Libor outlook:
Given the magnitude of the problem, it is reasonable for lenders to price in an appropriate risk premium in lending unsecured funds to term (such as 3 months). In Q4 2008, when the order of magnitude of losses was perceived to be 2-3 times larger, the 1Y 3mL vs. FF basis swap peaked at around 160bp. This swap currently trades at around 43bp. We don’t believe the relationship between the likely size of the losses and premium over a risk free rate will be linear, although the credit risk premium due to Europe should have a floor around a third of the peak level reached in Q4 2008 – say 40bp (one third of 160bp peak – 30bp median). A soft ceiling should perhaps be about 100bp, given that we are dealing with a smaller problem.
And again, European sovereign debt seems like it will be a recurring political risk in the years to come. Greece’s debt-to-GDP ratio will peak only in 2013, for instance. (And that’s if you believe the IMF figures).
Indeed, while it’s true, as Macro Man argues, that EMU break-up overall is unlikely, debt restructuring on a sovereign-by-sovereign basis is a very different prospect.
In short – it’s a changed world for Libor in the long term here, too.
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The (slow?) grind higher
So, whither Libor?
Gollapudi calculates a combined ‘current fair value’ of 100-150bps from these two scenarios. This is way over what the September Eurodollar futures suggest: 82bps.
Still, in the meantime, Monday’s rate came in at just under 51bps, the highest since July 2009. The grinding higher has begun.
It’s possible — given these two problems for Libor — that this will just have to be the New Normal, and interbank lending will steadily acclimatise to this conservatism.
Still, it’s nice for Libor to be interesting again.
More in the usual place.
Related links:
‘Heightened levels of interbank funding could be with us for some time’ – FT Alphaville
Two experiments – Aleph Blog
Libor revisited - FT Alphaville
Lamenting Libor – FT Alphaville