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:

View this document on Scribd

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:

View this document on Scribd

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…

Breaking out the Ginsu 2000 on the LIBOR Curves

I’m starting this post out with a tweet:

Behold, the kink in question:

You can see the spread between dollar and euro Libor is upward sloping up to 6mths, then falls at the 1yr point on the curve.  The question is why.

To answer that, I started looking at the points in the Libor curves to see what the trade-off was between maturities and basis points paid at the various maturities.  So here are the charts, which I hope to explain in a cogent manner:

Here’s how I created these:

• Collect rates at Libor curve maturities (o/n, 1mth, 3mth, 6mth, 1yr)
• Calculate the basis point differences between the maturities (1mth-o/n, 3mth-1mth, 6mth-3mth, 1yr-6mth)
• Plot over time.  Voila.

Another way to view the data is to look at the basis point differentials as curves themselves.  That’s what I did with these two:

Two things to note: I circled the rise in dollar Libor at the 3mth-1mth differential and the 6mth-3mth differential, but it’s also worth noting the rise between the 3mth-1mth and 1mth-o/n differentials, too.  It shows me the fear in the dollar Libor market is squarely in the o/n-6mth time horizon, even while the whole curve has shifted upward.  Meanwhile, euro Libor differentials have stayed anchored like a ship run aground with the exception of May 11, where o/n euro Libor spiked for some unknown/undisclosed reason.  My guess then was that either a bank had a funding problem or someone else was really bidding overnight funding up, just to stay liquid for 24 hours.  Either way, not a good sign.

Plus, the euro Libor curve shows a bit of a kink between the 6mth-3mth and 1yr-6mth differentials.  It could be that there’s a preference to get 1yr funding over 6mth, but it’s hard to say.

At any rate, what we can conclude is pretty clear: dollar Libor is where the action is and until we see these differentials at the front end of the curve relax, the bear flattener is on.

Buckle Up For Safety: Liquidity (Or Lack Thereof) In CDS

The issue of liquidity in CDS has been many people’s minds of late, myself included.  This piece from FT Alphaville, written by Gavan Nolan at Markit, is exceptional.  First, we have the ways market liquidity in CDS can be measured:

Bid/ask spread data (observed/calculated)

Number of dealers quoting (based on dealer runs)

Number of quotes each day (based on dealer runs)

Markit composite depth information from Markit’s end-of-day service

A liquidity score per reference entity-tier

via FT Alphaville » CDS liquidity update: Focus on European sovereigns.

These are all important indicators in determining liquidity.  I, along with other folks, have talked about liquidity issues in the CDS arena before:

But isn’t the 83.7% of trading by dealers “real”? If there are only 6 firms in the United States controlling the credit derivatives market and slightly more than that internationally, how can that be “real”? Since CDS positions are a zero sum game, all dealers combined can only be net long what non-dealers are net short, and vice versa. Just as in the used car analogy, we care only about the trading by retail car buyers, not the movement of volume between dealers, who still need to sell whatever cars they buy en masse. Moreover, we want as many price points from retail car buyers as we can get, so we want the www.kbb.com Kelly Blue Book prices, not the prices from one dealer’s lot.

via Kamakura Blog – Kamakura Blog: Sovereign Credit Default Swaps and Lessons from Used Car Dealers.

My hope is that the data from Markit will begin to get at the heart of some of these issues.  It looks like it will because a bunch of that data will show market breadth and depth.  Which many folks believe to be shallower than a kiddie pool.

But there’s also some disturbing – but expected – trends we see taking shape:

However, if we look at the bid/ask spreads this week, we can see that they have widened dramatically. This is to be expected – the CDS spreads of all five countries have widened sharply. But the expansion of the bid/ask spreads outpaces the widening in CDS spreads.

via FT Alphaville » CDS liquidity update: Focus on European sovereigns.

Why?  Call this a consequence of the BaFin ban.  And I don’t think it was unintended.  Indeed, as the Alphaville piece continues:

It is also evident that there was a big jump in the bid/ask spreads on May 19. This was after the German regulator Bafin announced a ban on naked CDS referencing eurozone sovereigns. The move created some uncertainty in the market and appears to have led to a disruption in liquidity. Overall, the disproportionate widening in bid/ask spreads in recent weeks suggests that liquidity has fallen.

This is just more of the same government heavy handedness directed at symptoms instead of diseases.  Don’t like reading about CDS quotes screaming higher on a day-to-day basis?  Ban their use; that will sort it all out.

Right.

Because as I pointed out before, viewing CDS strictly as “insurance” is wrong:

Liquid credit indices are just like liquid stocks.  You can buy/sell them in size, and pay very little for the privilege.  Illiquid credit protection, however, is a whole other ballgame.  You can’t get in/out of positions easily even in good times and you’re going to pay through the nose to do it.  And if you try to do a trade in size?  Puhleeeze…

This also illustrates why it’s laughable to think CDS have anything to do with making the sovereign credit situation worse. These are synthetic shorts when you buy them. If they didn’t exist, there would only be one option: sell the cash bonds and watch the yields & spreads blow out even higher than where they are.

via On Goldman, Synthetic Longs & Shorts, and S_ _ _ Sandwiches « Deep Thoughts by Professor Pinch.

So what are we going to be in for?  Most likely, reduced liquidity in the market.

And with reduced market liquidity, we get things like this…

Again…