Why LIBOR and Obscure Funding Market Metrics Matter

My friend Tim Backshall sent me this yesterday, which I think is worthy of considering for a couple of reasons:

First, the information he encapsulated in under 140 characters is fantastic stuff.  Noting rate rises like this – especially when a high/low like this is reached – is important stuff.

But there’s another reason, too.  It’s because commercial paper and overnight funding matters tremendously.  But to understand why, let’s look at a yield curve:

To build it, you need two things: an interest rate and a timeframe/duration of the credit.  Now to be fair, the CP market and the money markets are not the same as the bond markets.  They’re supposed to be safer, largely because they should be more liquid, the borrowers are supposed to be high quality credits, and the durations are usually really short.  Boring stuff.

But it’s been anything but boring…

The U.S. market for short-term IOUs, commercial paper, declined $10.2 billion to $1.06 trillion in the week ended June 2, the lowest since at least 1999, data compiled by Bloomberg show. Without seasonal adjustment, debt outstanding fell $5.5 billion, the fifth straight week of declines, to $1.05 trillion, also the lowest on record.

In Europe, financial companies’ overnight deposits with the European Central Bank rose to a record amid bank wariness of lending to each other during the continent’s sovereign debt crisis. Banks placed 320.4 billion euros ($389.9 billion) in the ECB’s overnight deposit facility at 0.25 percent, compared with 316.4 billion euros on June 2, the central bank said. That’s the most since the introduction of the euro in 1999.

via Loan Selloff Forcing Borrowers to Boost Rates: Credit Markets – BusinessWeek.

Here’s the latest and greatest charts that show the ongoing decline in commercial paper here in the US.  One is for ABCP (asset backed commercial paper) and the other is financial commercial paper.

Tim also put this out on Scribd, which shows bank lending and CP combined:

And in case you ever wanted to know what these instruments ever were, here’s the definitions:

Commercial paper consists of short-term, promissary notes issued primarily by corporations. Maturities range up to 270 days but average about 30 days. Many companies use commercial paper to raise cash needed for current transactions, and many find it to be a lower-cost alternative to bank loans

via FRB: About Commercial Paper.

As long as they are willing to continuously roll the paper over and the curve stays upward sloping, it can be.  But when the yield curve inverts, it gets expensive really fast.  So it’s generally not a good idea to rely heavily on the front end of the curve to finance, well, anything.  Duration matching, an interest rate risk management technique where your assets and liabilities are neutral to changes in interest rates, is a straight forward way to do this:

But why are they important?  Well, with short durations comes correlation to Fed funds.  And so through the Fed funds lever, the Fed tries to influence the nature of short-term rates and maybe long term rates by extension.  But truth be told, longer term rates are not as responsive to Fed actions as the front end of the curve.

But the Fed only regained its influence over the short end of the curve by moving to a target range on Fed funds (instead of a target rate) and by purchasing all those RMBS.  How do we know?  The spread between high/low quotes in daily effective Fed funds:

The dampened volatility of the recent past will only stay that way for so long.  Because like with European CP and European banks, we can see everything that’s happening over there happen over here again.  Why?

Our banks lend to theirs…



Filed under finance, International, macro, Markets, Monetary, risk management, Way Forward

4 responses to “Why LIBOR and Obscure Funding Market Metrics Matter

  1. Pingback: Friday links: bubbling up Abnormal Returns

  2. JM

    Hey man. Great work on the funding side of the issue. I’ve been looking at funding issues of the Spanish banking system, thanks to a comment on one fo your posts… oh boy.

    Before taxes and provisioning, Spanish banking operating net income is about 39.5 billion euros. Total capital and reserves of same is 232.2 billion euros.

    Spanish banks have 445 billion euro exposure to construction and property development loans.
    Already euro 165.5 billion of this exposure is troubled, only 4% written off.

    If 25% of these troubled loans are written off, it will result in just more than a complete wipe out of operating income. If you think 25% is a drastic assumption, consider than it is only a 9% write off total loan exposure. It could be much worse than this.

    Here’s the really scary part… the Spanish government is worried about becoming another Greece. So how can they recapitalize these banks, without a funding cost explosion? How much QE is the ECB willing to put out?

    Yet Santander is paying dividends. They remind me so much of Citi in 2008. But there may be no funding voodoo to make them a ward of the state zombie.

    • JM, that is awesome research. And no, I don’t think the assumption is drastic. I’ll put out something on Scribd later that looks at losses & recoveries on recent CMBS vintages.

      It’s like late ’07 & early ’08 again. Whistling by the graveyard…

      • JM

        I agree. Losses could be quadruple 9% before it’s over, and there is no fiscal firepower to “Japanify” the problem over time.

        This is the mechanism that will take equities to new lows. The financial system is working without a net, and massive bankruptcies will result.

        I had thought for a while that the steep yeild curve could finance banks out of this, but that is very unlikely. The Fed can only control long-term rates with QE, and that policy can only work on a scale really too massive to be acceptable.

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