The Spread: Libor and Fed Funds Rate
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Transcript of The Spread: Libor and Fed Funds Rate
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Armando, Arseny, Cory, Joe, Neekunj
SPREAD
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Question
Source: Historical data2
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BACKGROUND
LiborFEDHistoryWhy Libor Matters
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London Interbank Offered Rate
Average rate at which banks loan to
one another
LiborFED
HistoryWhy Libor
Matters
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Libor Calculation
16 Banks
10 Currencies
LiborFED
HistoryWhy Libor
Matters
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Federal Funds Rate
The interest rate at which a member institution lends immediately available funds to another depository institution overnight.
“2%”
FED (FOMC)
Target Rate
Open Market OperationsFunds Rate
LiborFED
HistoryWhy Libor
Matters
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1.Control Inflation1. Control
Inflation2. Promote
economic growth
FED & Central Banks
Federal Reserve Other Central Banks
LiborFED
HistoryWhy Libor
Matters
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Commercial Banks
Federal Reserve
(Central Banks)
Market Conditi
ons
Market Conditi
ons
PR
EM
IUM
LiborFED
HistoryWhy Libor
Matters
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The Credit Crunch
Washington Mutual Barclays Capital
Citigroup Lehman Brothers
Merrill Lynch UBS
Market Conditi
ons
Market Conditi
ons
LiborFED
HistoryWhy Libor
Matters
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Crisis Cycle ?LiborFED
HistoryWhy Libor
Matters
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Not US - ExclusiveLiborFED
HistoryWhy Libor
MattersLEGEND:CURRENT Sept 2007
Dec 2007
LEGEND:CURRENT Sept 2007
Dec 2007
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Why the Libor Matters
• Borrowing– Short-term interest rates– Forward rate agreements– Syndicated loans– Variable rate mortgages
• Financial Instruments– Derivatives - futures, forwards, options, and
swaps.– Floating rate notes
• Currencies
Source: WSJ, Apr 2008
LiborFED
HistoryWhy Libor
Matters
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IMPACT OF SPREAD
Borrowing CostsMortgage RatesBank ProfitsCounter Fed
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Borrowing Costs
• Borrowers v. Lenders• Businesses v. Consumers
Borrowing CostsMortgage Rates
Bank ProfitsCounter Fed
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Mortgage Rates
FED: 47 % Decrease
Mortgage Rates: 10% Increase
Borrowing CostsMortgage Rates
Bank ProfitsCounter Fed
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Bank Profits
% banks keep
Borrowing CostsMortgage Rates
Bank ProfitsCounter Fed
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Countering Fed
• FED was designed to protect / stabilize the economy– Government is not affective at setting
lending rates
Borrowing CostsMortgage Rates
Bank ProfitsCounter Fed
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REASONS FOR SPREADSeven Reasons
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1. Banks Hoarding Cash
• Banks holding onto cash/cash equivalents– Massive de-leveraging – Flight to quality assets like Treasuries as
opposed to inter-bank loans
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2. Fear of Counterparty Risks
• Ability of other banks to pay back loans has been called into question– Sub prime/credit crunch, capital
structure unknown – Lehman affirmed balance sheet
$27/share– Bear affirmed balance sheet
$60-80/share
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3. Role of Bank Write Downs
• Many banks/I-banks highly leveraged and have risky positions– Insufficient capital / collateral to finance
loans
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“Worst of the Credit Crisis may be over.” - Henry Paulson, May 7, 2008
4. Symptomatic of Financial Crisis
• Where there is fear of uncertainty, premiums must be paid.– Risk premium rising, credit crunch still
continues
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5. Liquidity Issue
• Trillions of US dollar positions tied to LIBOR, not enough $ to go around
• Fed as of Sunday expanded creditfacilities to allow use of risky collateral
• Banks less likely to borrow from Fed, Fed is lender of last resort
• Banks don’t want perception that they are in trouble
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6. Predatory Lending
• Banks are interested in limiting exposure to a concentrated amount of banks– Bear’s trades not cleared by Goldman then
other trading partners– Survival of the Fittest (biggest)
GoldmanBear Stearns
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7. Clean balance sheets
Banks are interested in keeping strong cash positions on balance sheets– Banks want to show the market they have
adequate cash and liquidity in case of a market fall out
– Bear Stearns Liquidity issue not a capital issue
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SOLUTIONS
Inject Liquidity
Creation of NYBor
Expand US Libor
Tighter Scrutiny of Banks
Time?
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1. Inject Liquidity
Who would really be paying the price?27
Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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To the Rescue!
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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Moral Hazard
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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2. Creation of a NYBOR
• Would only track borrowing costs of US banks only.
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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3. Expand US LIBOR
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Inject LiquidityCreation of NYBorExpand US Libor
Tighter Scrutiny of BanksTime?
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Expand the LIBOR
• Expand the panels of banks which report their borrowing costs to LIBOR– More complete, reflective average
• Increase the accuracy of the benchmark by better capturing the US market.
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Inject LiquidityCreation of NYBorExpand US Libor
Tighter Scrutiny of BanksTime?
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4. Tighter Scrutiny on Banks
“…tighter governance of the rate-setting process. This means broadening the Foreign Exchange and Money Markets committee that oversees Libor and creating a new group that would scrutinize the data submitted by banks.”
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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5. Time?
• We can use the history to examine the present and predict the future.
• Easy and comforting to call it “cyclical” and say we’re between crests.
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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• What happens when the present has never been seen before?
• We are in unknown territory, and no one knows how deep this will go…
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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This could be
you.
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Inject LiquidityCreation of NYBor
Expand US LiborTighter Scrutiny of Banks
Time?
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Thank you
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