Alex,

Generally agree with your sentiment on cds spreads and likelihood of further credit dislocations, but interbank rates have not been rising--- short-dated libor sits right on top of fedfunds.

Regards,

Dick

 I am glad this came up, because it allows me to address a mis-conception of many journalists and others covering this credit dislocation.   

Here is a http://www.wilmott.com/blogs/satyajitdas/index.cfm/2008/2/12/Better-TED-Than-Dead--The-Tale-of-Interbank-Rates" title="TED Spreads now widening - again.">blog entry of a very bright guy on the credit markets, and he summarizes the current situation quite nicely.

Few banks are getting straight LIBOR these days.  This is more difficult for me to confirm, as one cannot just get it off Bloomberg.  But this is what I have heard from my market contacts in banking, and its confirmed by the CDS spreads.  Variances from LIBOR have usually been the case, but these were much more narrow when risk seemed to have "disappeared".  Today almost all of the major banks are paying a significant spread premium to LIBOR, borrowing between themselves.  It does make sense that certain partipants will need to pay more for their risk, actually.  For instance, there is no way that IndyMac is going to get the same rate as a major Japanese bank.  The latter seems to be an exception, since (so far) they have not been sucked into the credit crunch.  The former looks pretty hard up. 

So if one looks at the spread widening, it is negating relatively subdued LIBOR reduction, and that has lead to overall borrowing costs remaining about the same in nominal terms, or even going up, depending on the bank.  That was my point actually. 

The CDS spreads widening at an alarming rate are simply following the LIBOR spread increase.  In a sense, one is confirming the other. 

For some reason, my link is busted.

Here it is again.

Just to keep things straight...

LIBOR is set each day by averaging the actual interbank offered rates of 20-35 major global banking institutions.  After some spikes around year end, LIBOR has been moving lower with Fed-dictated fed funds rate and currently speads a bit narrowly to fed funds in anticipation of futher rate reductions.

TED SPREADS/swap spreads chart differences between Treasury (theoretically) risk-free rates and LIBOR for the same period.  To the extent that the creditworthiness of the banking system grows less certain due to macro and credit/market difficulties, the TEDS have and will widen.

Credit Default Swap premia/"costs" increase as the creditworthiness of individual institutions or classes of institutions or securities types are percieved to weaken.  They have definitely been increasing for most institutions/securities.

IndyMac is a damaged institution and it's almost certain that interbank or other credit offerings to such an institution are substantially higher than LIBOR to compensate for the increased risk of loss.

And Citigroup is also a damaged institution, paying higher than average rate to LIBOR, both on the LIBOR market and outside of it as well.  And many other major banks are paying more than LIBOR in OTC positions outside of the LIBOR market.  At least that is what I have been told. 

In terms of the LIBOR market, while the average may be a certain number, it does not necessarily have a close correlation to all its constituents.  Spreads between institutions have widened considerably.  That was one of my points. 

But you may be wondering, how can everyone be "above average"?  This is where I am getting into my point, which is a discussion about OTC inter-bank borrowings not captured by LIBOR.  LIBOR only takes into account transactions on the London Interbank market.  It does not take into account far larger (or below "market size") transactions, and more common OTC transactions between institions...especially with longer terms.  LIBOR is an indicator of the "cleanest" portion of the interbank borrowing market, but it is not even close to the entire market. 

Hidden within these transactions, not captured in the LIBOR market, which are far larger than those in the LIBOR market, are the increases in cost of funds I discussed.

http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=225&a=1416

But lets try to step back from minutiae for a minute.  If CDS spreads are rising for the major banks in aggregate, there has to be some knock-on increase in their cost of funding.  Otherwise, CDS traders would make a wonderful book of arbitraging the difference between borrowings and CDS spreads.  It would be the perfect opportunity for a form of basis capture arbitrage.  Duration difference between short term borrowings and certain CDS exposures could explain part of the difference, but one could simply structure a contract to match duration, and capture the difference anyway.  And yes, CDS spreads for all publicly traded durations have been going up in lock-step.  That is my fundamental premise in believing the "borrowing desk" intel I have gotten. 

The TED spread is yet another way of showing that interbank borrowings are higher than average.  But that is not primarily why I posted this entry.  It was the discussion of CDS spreads I was focusing on.  I can see how introducing a post with a new concept would be confusing, so sorry about that.  Still... the point is reinforced by the TED spread, which I suppose you are acknowledging with your clarification. 

Discussing the fine details of how LIBOR is constructed, how the TED spread is calculated and what it means, these are all useful things to point out.  Also, your questions and clarifications have made me think this through considerably more deeply that I did originally.  Thanks for that, it was very helpful to me. 

But can we agree that bank cost of funds has likely increased, most especially relative to yields on the asset side, resulting in pressure on net interest margins?  That is the crucial point I am focusing on.  If not, what is your position on this issue, and what is your support for this position?

As further clarification on LIBOR and what it measures, here are a few tib-bits from the BBA website:

http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=141

How Panels (institutions) are chosen to build the index, and what transactions are used:

"Decisions on individual banks were taken on the basis of scale of activity in the London market, perceived expertise in the currency concerned, reputation, and due consideration of credit standing. Current and potential panel members were asked to provide data confidentially to the BBA about their cash and short-term FX swap business in each currency in order to measure their scale of activity."

So clearly, this is a sample of a sample, and that sample is determined subjectively based on the amount of business these banks do with this market, and their perceived "quality".  This is hardly the entire inter-bank market.  Its not even close. 

I assume we are talking about US dollar LIBOR, since it is the most commonly referred to LIBOR index, and it is also the closest to Fed Funds rates.

The 2007 Panel (no 2008 up yet) of banks for determining this rate:

US DOLLAR (USD) – 16 BANKS

Bank of America  (5 year CDS spread of 80 bp approx)
Bank of Tokyo – Mitsubishi UFJ (5 year CDS spread of 43 bp approx)
Barclays Bank plc
Citibank NA (5 year CDS spread of 100 bp approx)
Credit Suisse
Deutsche Bank AG
HBOS
HSBC
JP Morgan Chase (5 year cds spread of 85 bp approx)
Lloyds TSB Bank plc
Rabobank
Royal Bank of Canada
The Norinchukin Bank (5 year CDS spread of 40 bp approx)
The Royal Bank of Scotland Group
UBS AG
West LB AG

Sorry I am not more precise on the CDS rates, I don't have my access to Bloomberg right now.  One year cds rates are lower accross the board of course, but the differentials between banks is still about the same.  I think I will put someone on looking up the rest, especially for one and five year CDS, and do a few charts for me. 

Capecod, thanks for making me do all this.  I just took a lot of this as a given, but had not applied the rigor to look a lot of these things up.  I knew the panels were a limited selection of banks (of course), but did not really understand what "limited" meant. 

I hope I am not boring the crap out of anybody.  Frankly, I find all of this fairly interesting.  Once I do some more research, I will make a follow-up post. 

No argument with your general thesis...just overly pissy about some of the language (sorry).  Anyhow, I do find the relative size and order of CDS 5-yr spreads for JPM, BAC, and C fascinating.   General press accounts I've watched leave (at least me with)an impression and expectation that the order of market-judged crediworthiness here is correct, but that BAC and JPM would be separated by a much greater amount from C and that they would also be separated to a greater extent from each other (with BAC still on top).   Speculation: until BoA walks away from CFC or we have better numbers on the CFC portfolio, I suspect the worry will continue that BoA swallowed a black hole. (?) 

Side query: During all this recent turmoil, are there any developing probs keeping "clean" market risk and credit risk measures to avoid over-reserving?   Since vols escalated pretty precipitously, are backtests nicking institutions with outside days? Just interested for old times sake.

D  

In my opinion, you are not overly picky about my language.  I felt you had every right to require me to clarify what I was talking about, and in fact I needed to do a bit of work myself to tighten things up a bit.  So I thank you for your comments. 

You clearly have a strong technical knowledge of this area, so I am actually learning a thing or two from you.  I have no problem with that.  At least you didn't just vote me down and not bother to post. 

You side quiery is outside of my scope of everyday knowledge, and that disturbs me!  Especially because its a good question.  I am primarily a credit risk guy, working in risk management team, and the market risk aspects are handled by another group on that overall team.  But I will ask around, and see how expected loss reserves have been impacted by these developments.  I would say that generally, banks have made light work of counter-party credit risk in general, when it comes to reserve methodology.  And that would imply they are probably scrambling to figure out how to handle this.  But I have not worked on a mega-bank's methodology in many years.  So I don't feel I have the experience or current field knowledge to make a confident comment on this subject.