Introduction
Hi, I'm Dan Peirce from the Global Asset Allocation team here at State Street Global Advisors. As financial markets hash through a recovery from their first-quarter disarray, equities have been finding support, and many credit spreads have narrowed considerably. But conspicuously slow to reflect any desire for normalcy have been the widely followed Libor indexes.

For example, three-month London Interbank Offered Rates in US dollars, British pounds, and euros have recently been maintaining steep premiums of 70 to 80 basis points over the corresponding short-term interest rate targets established by the respective central banks (Slide 1). These are remarkable spreads, especially with no sign of rate hikes on the near horizon.

Slide 1: Libor/Short-Rate Targets

In this video, I'd like to discuss Libor's role as a benchmark, the stresses that high Libor levels seem to reflect, and potential market implications for investors.

Libor as a Benchmark
First, though, let's define exactly what we mean by the London Interbank Offered Rate. Each day at 11 a.m. London time, the British Bankers Association canvasses selected banks for the interest rate levels at which they are offered interbank funds. The poll covers 10 currencies at 15 separate maturities, extending from overnight to one year. Indicated rates at each maturity are averaged across the banks, eliminating any extremes, and for each currency, a set of Libor fixings determines a yield curve from overnight to one year.

Because Libor directly reflects the cost of funds available among major banks, it is a natural benchmark for many forms of lending. Corporations often borrow at floating rates set to Libor plus a specific spread. In consumer lending, many adjustable-rate mortgages are tied similarly to Libor, with the maturity of the Libor benchmark corresponding to the frequency of adjustment. The interest-rate swap market enhances this marketplace by allowing borrowers and lenders alike to swap floating Libor payments for fixed amounts.

The basic financing process is tacitly assumed to involve relatively unimpeachable bankers seeking to lend circumspectly and profitably to somewhat more impeachable borrowers. But the credit collapse that began in 2007 with subprime mortgages has propagated mercilessly through the financial system, taking a heavy toll on many major banks.

As a result, previously fluid interbank dealing has acquired a notable viscosity. The banks are no longer a clear world apart from the end users of credit to whom they charge a premium. Indeed, given the complexity of securitized product still extant, traditional banking opacity makes it even more difficult for funding to flow freely through the interbank market.

TED Spread
The TED spread has long been a popular barometer of interbank malaise. Years ago investors tended to watch futures contracts to track this relationship between Treasury bill and Eurodollar rates. Bill futures have since gone dormant, and the focus shifted to the yield difference between the underlying Treasury bills and Libor levels. This spread did widen sharply in the middle of 2007, but because Treasury bills often seem to attract a safe-haven constituency that has does not use the interbank market, the TED spread may not be the cleanest measure of interbank worries.

OIS Spread
More prominent of late has been the spread between Libor and the Overnight Indexed Swap (OIS) rate. An overnight indexed swap exchanges a fixed level of interest, the OIS rate, for the amount earned by fed funds over the term of the swap. The counterparties to such a swap bear minimal credit risk, as they simply make payment based on the difference between a fixed rate and a stream of variable rates. With a conventional Libor loan, by contrast, the lender bears the credit risk of the borrower for the entire principal plus the Libor interest.

As a result, the Libor/OIS spread is perhaps the clearest indication of pure counterparty risk. Like the TED spread, the Libor/OIS spread surged in August 2007. Formerly ensconced comfortably in the neighborhood of 10 basis points, the three-month Libor/OIS spread has fluctuated wildly in the past year, even exceeding 100 basis points for several days in December 2007. But the spread remains elevated in 2008, with recent readings holding well above 80 basis points.¹

Despite the liquidity facilities arranged by central banks and the massive influx of capital into troubled financial institutions, the Libor/OIS spread reflects persistent nervousness in the global banking system. The multiyear issuance period for complex assets that have since become impaired suggests that confidence in bank balance sheets will only return gradually, as the slow but steady lessons of cash flow experience help frame balance sheet valuations.

Implications for Investors
In the meantime, borrowers whose payments are tied to Libor are facing higher financing costs than they would have had to pay if interbank lending were still functioning as smoothly as it did before August 2007.

Slide 2: Libor/OIS Spread

Of course, without the banking system dislocations, it seems unlikely that the Bank of England or the Federal Reserve would have cut rates as much as they have in the past year. And maybe the European Central Bank would have even lifted rates by now.

Elevated Libor premiums are uncomfortable, to be sure, but the overall level of short-term interest rates can hardly be deemed onerous. Non-financial borrowers who still have access to credit are not likely to be unduly burdened by the sticky Libor wicket; the situation is more problematic, as well it should be, for financial institutions whose balance sheets are gummed up with too much inscrutable paper.

Equity investors, therefore, should not fret too greatly about unusually punitive Libor spreads, provided they avoid buying shares in financial firms with constrained access to funding. Money tied up in expensive government bonds might reconsider equities if inflation or economic activity picks up more noticeably. Meanwhile, short sellers and cash-heavy institutions should serve as a cushion for share prices. And if Libor spreads can embark on the same kind of narrowing trend that many longer-term credit markets have already been enjoying, yields on cash may erode further, even in the absence of additional interest rate cuts. Such a trend has the potential to reinforce recent declines in risk aversion, to reduce further the appeal of safety trades, and possibly even to spur major equity averages back towards the highs that they achieved in the fall of 2007.

Thank you.

Posted On: June 03, 2008