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Tuesday, October 14, 2008 11:20 PM

LIBOR and the TED Spread Still Show Extreme Stress

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Lost in the euphoria of Monday's rally, LIBOR and the TED Spread still reflect extremely tight bank to bank lending conditions. Let's take a look.


One month LIBOR is normally some small percentage (say 15-30 basis points) above the Fed Funds Rate. It is now 297 basis points above the Fed Fund Rate.

The key issue with LIBOR is the huge number of adjustable rate mortgages that are tied to it. Bernanke went on a slash and burn campaign of cutting interest rates from 5.25 all the way to 1.50 (375 basis points) yet LIBOR only picked up about 100 of them.

Mortgage Rates

The above charts courtesy of Bloomberg.
Notice that mortgage rates across the board are higher than they were a year ago.

$TNX 10 Year Treasury Yields

click on chart for sharper image

The above charts shows although mortgage rates are higher than a year ago, 10-year treasury yields are 50-70 basis points lower than a year ago as depicted by the blue circles in the above chart. In addition, fees (points) are higher now, so are down payment requirements, and so are FICO score requirements.

Note that last spike up ending in that second blue circle. Yields on the 10-year treasury are spiking because of the cost of these bailouts.

Ted Spread

click on chart for sharper image

The TED spread is the difference in yields between inter-bank and U.S. Government loans.

Initially, the TED spread was the difference between the interest rate for the three month U.S. Treasuries contract and three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.

The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments.
Credit Markets Unimpressed By Bailout Plans

Mortgage rates are rising, the Ted Spread has barely budged, and 1 month LIBOR is almost 200 basis point higher than it was just one month ago. LIBOR should be 50 basis points lower on account of a 50 basis point cut by the Fed.

For all the euphoria in the stock market, the credit markets certainly are unimpressed. And that my friends is what matters most.

Mike "Mish" Shedlock
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