Warning: Involves math concepts (no Greek letters though) and general wonkishness
I mentioned Dr. Donald van Deventer’s work in a post from earlier this week, and I felt he wrote about some really interesting – and telling – issues that may be present in the LIBOR and funding markets. I’m going to touch on them, what they mean, and why I think they’re important.
Let’s start with a key observation he makes:
We’ve observed two trends in recent entries on this blog. The first trend is to note the relatively modest volume in corporate and sovereign credit default swaps that has been reported by www.dtcc.com. The second is to note that the implied forecast for interest rate swap spreads has recently been strongly affected by Eurodollar quotations on the Federal Reserve’s statistical release H15. Movements in 1, 3, and 6 month Eurodollar rates reported by the Fed have moved in stair-step fashion and in diverse ways for the three short term rates. These movements have been so concerning that we asked the same question we posed in the CDS market: Are the rates we’re seeing really real?
Indeed. The things he noted regarding CDS data – and the lack of true liquidity – can actually be extrapolated across a variety of industries. Whether its a concentration of assets and deposits in financial services or the oligopoly that Food, Inc. takes on in food processing, it seems like we have a cross section of our economy where there are fewer – yet much larger – businesses we’re relying on to provide us with the goods and services we want and need. Don sees it in the CDS data, making the analogy between inter-dealer CDS trading and used car dealers trading/swapping auto inventory. His question about the legitimacy of quoted rates is a valid, yet pointed one. Hopefully we can shed some light on this.
FIrst, here’s a paper from the BBA which shows how they calculate Libor:
The important thing to remember is the Libor fixings are an average. Outlier banks are thrown out. Plus, I imagine you can have different panels at each maturity. Indeed as Don points out:
By definition, this calculation process will generally result in Libor quotes that are “too low” for much of the panel and too high for some of the panel banks as well. During this period, the long held image of the Eurodollar deposit market as a homogeneous market where all but the worst banks paid the same rates was clearly inconsistent with the reality of the market place.
So in that sense, rates quoted may not match the reality of the marketplace. But to the point Don made about different banks paying different rates, which violates the general principle of homogeneity, we see that here in the US as well. It’s why Countrywide, Washington Mutual, IndyMac and others would pay more for deposits than other institutions during the beginning of the credit crunch. High payout rates on deposits imply a bank could be in trouble.
Also Don’s post had this chart:
I replicated the 1mth constant maturity Treasury and 1mth Eurodollar rates in the following chart, but with updated data:
The two time series had a correlation of 0.39, so while it exists, it’s somewhat weak. The correlation strengthens as you go to 3mth rates (0.53) and at 6mth rates it’s higher still (0.61). I also went ahead and created a chart that shows a 5 day moving average of these rates, thinking that we may see something in a moving average chart that we don’t see in a chart that just shows coinciding rate moves.
Correlation is 0.41, so it’s still weak. Then I went ahead and created a chart of the spread between the two rates:
The spread is moving higher, which implies the 1mth CMT is very well bid, as those rates have been heading south while the Eurodollar rates are headed north. What does that mean? Well, it means risk in the banks is headed higher. As Don says, Libor and Eurodollar rates only have a correlation of 50.9%, so it’s still weak. But take a look at what he points out right after that:
BBA Libor series correlation with panel average default rate: 35.5%
Federal Reserve H15 series correlation with panel default rate: 85.0%
The Eurodollar rates have very high correlation with the panel default rate which tells me three things:
- The dash for dollars is still on full bore. Eurodollar rates are rising because dollars are scarce. The Euro is irrelevant.
- Libor rates don’t accurately reflect default risk, and that’s partially by design. Winsorizing the data (removing extreme values) will always give you an incomplete picture because the riskiest firms are eliminated along with the least risky. Libor only works as a reflection of credit risk when there is a systemic issue and that’s rare.
- Lastly, the Eurodollar put strategy for playing a bear flattener is the best way to go if you believe there’s a funding issue in the credit space or you just want to express views on the shape of the curve.
That’s it for now, class dismissed.