The Spread: Libor and Fed Funds Rate

Armando, Arseny, Cory, Joe, Neekunj

SPREAD

1

Question

Source: Historical data2

BACKGROUND

LiborFEDHistoryWhy Libor Matters

3

London Interbank Offered Rate

Average rate at which banks loan to

one another

LiborFED

HistoryWhy Libor

Matters

4

Libor Calculation

16 Banks

10 Currencies

LiborFED

HistoryWhy Libor

Matters

5

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

6

1.Control Inflation1. Control

Inflation2. Promote

economic growth

FED & Central Banks

Federal Reserve Other Central Banks

LiborFED

HistoryWhy Libor

Matters

7

Commercial Banks

Federal Reserve

(Central Banks)

Market Conditi

ons

Market Conditi

ons

PR

EM

IUM

LiborFED

HistoryWhy Libor

Matters

8

The Credit Crunch

Washington Mutual Barclays Capital

Citigroup Lehman Brothers

Merrill Lynch UBS

Market Conditi

ons

Market Conditi

ons

LiborFED

HistoryWhy Libor

Matters

9

Crisis Cycle ?LiborFED

HistoryWhy Libor

Matters

10

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

12

IMPACT OF SPREAD

Borrowing CostsMortgage RatesBank ProfitsCounter Fed

13

Borrowing Costs

• Borrowers v. Lenders• Businesses v. Consumers

Borrowing CostsMortgage Rates

Bank ProfitsCounter Fed

14

Mortgage Rates

FED: 47 % Decrease

Mortgage Rates: 10% Increase

Borrowing CostsMortgage Rates

Bank ProfitsCounter Fed

15

Bank Profits

% banks keep

Borrowing CostsMortgage Rates

Bank ProfitsCounter Fed

16

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

21

“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?

To the Rescue!

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Inject LiquidityCreation of NYBor

Expand US LiborTighter Scrutiny of Banks

Time?

Moral Hazard

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Inject LiquidityCreation of NYBor

Expand US LiborTighter Scrutiny of Banks

Time?

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?

3. Expand US LIBOR

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Inject LiquidityCreation of NYBorExpand US Libor

Tighter Scrutiny of BanksTime?

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?

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?

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?

• 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?

This could be

you.

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Inject LiquidityCreation of NYBor

Expand US LiborTighter Scrutiny of Banks

Time?

Thank you

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