The Big LIBOR Failure.

LIBOR - London Interbank Offer Rate.

LIBOR rates have fallen drastically since surging to obscene levels in October, helping the uninformed to believe that the credit crisis was easing...silly rabbits.

The drop in LIBOR signals a sharp improvement in market sentiment at a time when central bank interest rates are at historically low levels.

Low LIBOR rates, the amount banks charge each other to borrow short-term from overnight to a year, should stimulate lending in the financial markets and therefore boost economic growth. Three-month LIBOR rates are used to price Trillions in financial products worldwide. Hence lower LIBOR rates should also reduce the cost of issuing billions of dollars of bonds, loans and structured products.

The current 3 month LIBOR is at .60125



Also OIS Spreads (3M LIBOR to Over Night Risk Free Rate), which is measure of credit risk has improved greatly since the Lehman/AIG mess.

But is LIBOR telling the whole story? Is LIBOR painting a totally different lending picture then what is actually happening in credit markets?

That is because there are wide differences between the rates at which individual banks can borrow. The biggest institutions are able to fund themselves at around LIBOR levels while smaller institutions have to pay, in some cases, more than 100 basis points above LIBOR. This is explained by continuing counter party risk in what remains an uncertain economic environment. This is in sharp contrast to before the credit crisis when all institutions paid similar rates to borrow.

So, is the fall in LIBOR a positive sign for the markets? Not really, because we have a very tired credit market, where many smaller banks are still having to pay relatively high rates to borrow, as what we are seeing is a huge difference in the price of borrowing for individual banks. There is a higher proportion of banks paying above LIBOR.

The British Bankers’ Association or BBA which sets LIBOR by compiling an average cost of lending from the 16 banks, have been defends its rate, stressing that the market understands it is a reference point for the strongest banks, but even the BBA has found some flaws, and they are in the midst of revamping the dissemination of LIBOR.

But then again, LIBOR is so low because US Short Rates are so low, is really 100 basis points above stated LIBOR a bad thing? That's open to discussion.

Also, Central banks have helped the market, too, by providing vast amounts of liquidity in secured lending, where banks and institutions can raise money at low rates in exchange for collateral.

However, the higher rates the smaller institutions have to pay in the unsecured lending markets, which were the most flexible and easiest to access before the credit crisis, will slow recovery as the higher costs will act as a drag on their earnings and mean institutions will take longer to recapitalize. Institutions also face difficulties funding much further out than three months as banks are reluctant to lend beyond this period due to counter party risks. And when they do so, it is at punitive rates.

At the same time, funding in the longer-term corporate bond markets is very expensive.

The bond markets, where bond funds and asset managers are the main lenders rather than the banks, may be open with issuance at record levels, but the costs for an investment grade company is nearly 200 basis points more than it was at the start of 2008.

The average rate for a triple-B rated company to issue bonds in dollars is 7.75 per cent compared with 5.92 per cent in January 2008.

So funding and debt issuance is actually more expensive then it was before.

LIBOR currently is very misleading. The published levels may be very low compared with recent history, but in reality most are not convinced much volume is going through beyond the one-month maturity. Furthermore, if institutions want to fix their debt over a longer term they have to pay enormous rates to do so. The fall in LIBOR rates is not a great guide to what is happening in the overall economy. The credit system is definitely in for a long haul, and it won’t get back to a situation where banks are lending in the way they were before the credit crisis for a long, long time.

BANK ON THAT.