Since this recession began with a freezing of the credit markets, indicators that measure the health of the credit markets are extremely important. In October 2008, Alan Greenspan made a speech arguing that the credit markets would not return to normal until the LIBOR-OIS spread returned to "normalcy." This post will attempt to explain what the LIBOR-OIS spread is and its importance/background to the current recession.
Essentially what the LIBOR-OIS spread does is measure the difference between the interest rates that banks can borrow from each other for and what they can borrow from the Federal Reserve for. LIBOR stands for the London InterBank Offering Rate. Each day, economists in London call about 50 banks spread throughout the world and ask them how much they charged (what the interest rate was) other banks to borrow from them. This "interbank" market is very important because banks can borrow from other banks to maintain healthy Reserve requirements. With out the interbank market, banks would be like you and me and the average business would be without banks: always in danger of being unable to invest or even to pay bills.
The OIS stands for the Overnight Index Swap and measures the interest rate that large banks are charged to get a loan from the government. It is just another tool to ensure the health and well being of financial institutions.
Whatever the difference is between the LIBOR and the OIS measures the willingness banks are to lend to other banks. If Bank A thinks Bank B is going out of business tomorrow they will not lend them money or they will charge them very high interest rates. So if LIBOR sky rockets, something in the economy is screwing with bankers confidence and this is never a good thing.
The average LIBOR-OIS spread (spread being the difference between the two) was .1% for the 18 months leading up to the recession. For example, the LIBOR was at 2.9% and the OIS was at 2.8%. A huge exogenous shock occurred on September 8, 2008: Lehman Brothers was allowed to file for bankruptcy. This sent the LIBOR to 6%, while the OIS remained constant (at about 3%). That means that the LIBOR-OIS spread went up to 3.00%- ten times the average spread!!!
At this point, the failure of Lehman Brothers, everything went awry. Within a few hours, AIG was on the brink of bankruptcy, WAMU went bankrupt, Wachovia went bankrupt. The stock market plummeted and people finally started paying attention to how bad the mortage backed security market really was.
It was also at this point that Bernanke started enacting drastic measures to increase lending. Using the LIBOR-OIS spread as a gauge, he implemented a plan that would increase the Fed's balance sheet (and thus the money supply) to increase the financial systems ability to lend money to other institutions.
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Looking at some graphs of the LIBOR-OIS spread on the web, it seems that it's upside down, atm. Before August 2007 the OIS was higher than LIBOR (which makes sense since a lending bank would have to charge less than the government for a loan, or they would get no takers, right?), but now the LIBOR is (slighly) higher than the OIS. It's a much smaller spread that it was at the worst, but it's still negative.
ReplyDeleteWhy would anyone get an interbank loan if they can get a government loan for cheaper?
I'll have to take a closer look at this, however by my research the 3 Month LIBOR is at .5% and the rate banks can borrow from the Federal Reserve at is at 0-.25%. So the spread has essentially decreased to 25-50 basis points. What you may have been looking at is the Fed Funds Rate, which is the rate the Federal Reserve would like to see the the interbank market charging for loans. However, if a bank could go to the government at any time and get a loan through the discount window banking would be a very easy job, which is why only certain banks can easily access the discount window. The difference between the LIBOR and the Fed Funds rate or the Discount rate simply measures the amount of fear that is taking place within the banking system as a whole.
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