The London InterBank Overnight (lending) Rate [LIBOR]nearly sky-rocketed yesterday,
The rate banks charge each other for overnight loans surged to an all-time high of 6.88% on Tuesday after the U.S. government voted to reject a US$700-billion bailout plan for financial firms.
The London interbank offered rate, or Libor, which is set by 16 banks, rose the most ever, jumping 431 basis points. The Libor-OIS spread, which is considered a gauge of the scarcity of cash, also hit a record, widening to 246 basis points
“The money markets have completely broken down, with no trading taking place at all,” Christoph Rieger, a fixed- income strategist at Dresdner Kleinwort told Bloomberg. “There is no market any more. Central banks are the only providers of cash to the market, no-one else is lending.”
The US Federal Funds rate target set by the Fed is 2%, and yet banks are unwilling to lend to each other overnight at annual rates much less than 7%. What does this mean?
The banks are demanding liquidity like mad, and those who have it are afraid to put it out at anything other than rates approaching junk-rates. There is so much concern among the bankers that even overnight the bank to whom they lend funds might go belly-up that they won't make such loans unless they are well-compensated for taking the risk.
This is not a liquidity trap, though. The banks are willing to lend overnight funds at what they see as appropriate risk-adjusted rates [i.e., contrary to scare quotes, the market still exists and has not broken down]. Rather, this situation is a reflection of the risk in the banking system, due to imperfect information about the credit-worthiness of the borrowers. As the dust settles and actors in the money markets acquire more information about the states of affairs among potential borrowers, look for this spread between LIBOR and the US Federal Funds rate to narrow again.
For more on interest-rate spreads, see this by Jim Hamilton.
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