Wednesday, June 11, 2008

LIBOR our only hope? No... there is another!

ICAP's, the largest broker of inter-lender transactions, has developed their own measure of U.S. inter-bank lending rates, ostensibly to supplant LIBOR. The first survey of New York banks was conducted today, and resulted in a 3-month rate 1.7bps lower than LIBOR.

Backing up a minute, LIBOR is supposed to be a measure of where very large and highly rated banks can borrow. Recently the accuracy of LIBOR has been called into question, some have gone to far as to say manipulated. U.S.-based banks in particular have complained that LIBOR, as currently constructed, is destined to fail as an accurate measure of U.S. lending rates.

This is because LIBOR is set by surveying 16 banks as to where they think they could borrow in U.S. dollars for various terms ranging from overnight to 1-year. Of the 16, only 3 are actually American: Citigroup, J.P. Morgan, and Bank of America.

Enter ICAP. Their survey will involve U.S. firms only, and will ask where the bank would lend to a un-named A1/P1 borrower for terms of one and three months. Called the New York Funding Rate (NYFR), it was set for the first time today at 2.4646% for one-month and 2.7715% for three-months. LIBOR reset today at 2.47688% and 2.78813%. Both are a little better by 1bps in the ICAP survey.

So what does this mean? LIBOR has been rising, from about 2.64% in late May to its current 2.79%. That 15bps does not reflect an increased probability of Fed hikes, at least not entirely. It reflects continued concern over the health of banks.

The fact that the NYFR was set lower would indicate that U.S. inter-bank liquidity is slightly better than in Europe. This is consistent with a widely held view that the risks in U.S. banks have been better disclosed when compared to their European counter-parts.

The swaps market reacted favorably, with 2-year swaps falling by 2bps and the rest of the stack falling by about 5bps.

In my opinion, fear about LIBOR is yesterday's news. The Fed has supplied access to tremendous liquidity to both banks and primary dealers. As a result, the jump-to-default risk has been greatly reduced. But that hardly leaves me bullish on banks or brokers. Today's market troubles are about a real lack of earnings power among financials. Take Merrill's downgrade of Lehman Brothers today. The analyst (Guy Moskowski) said...

"We expect LEH to survive because its liquidity profile is strong and the Fed discount window is open... but current business and asset mix are just not well positioned for the current environment."

I think you could insert dozens of bank/broker tickers into that sentence. He also discusses Lehman's book value (currently $33/share) but with little earnings growth in the near term, why would anyone pay close to book for the stock?

My point is that rising LIBOR was more about jump-to-default risk, which I think has abated substantially. So that's yesterday's problem. Today's problem is that banks have plenty of credit losses coming and so that will be tying up capital. They can't be turning in strong earnings if they are using capital on REOs. They also are facing weaker net-interest margin should the Fed start hiking rates.

Now I'd have to think that if I could look into a crystal ball and know for a fact that Lehman Brothers would survive as an independent entity one year from now, then I'd bet the stock would be a good bit higher. I'd say the same think about National City or Washington Mutual or CIT. But the odds are fair that each of those firms will seek a stronger partner sometime in the near future, and the merger price won't make the stock worth owning.


viking said...

good points
well taken

what are your thoughts about the impending CDS detonation? by now its clear it all hinges on the bond hedges

too much insurance was written

this is the market behind all markets

and its totally fucked as a mathematical certainty

you would have to really be denying reality at this point not to realize that its the CDS market, stupid, just like it was the EQUITY INSURANCE market in the Depression.

It's a lock that the CDS market fails. Look at what happened to XL Capital today! It's coming for everyone who wrote those swaps.

Those swaps allowed the leverage. Without the insurance they are way past the shark nets, comprende? Like miles past the shark nets. With blood in the water.

CDS is the reason they are ALL TO BIG TO FAIL

What will the attempts to bail out CDS look like? will it work? can it work?

i would appreciate your thoughts

Anonymous said...

Thanks for the NYFR illustration, but doesnt it basically suffer from the same flaw as the "original" LIBOR? Namely, that the rates are what the banks think they might lend hypothetically in some hypothetical transaction... this is not the same thing as saying this is where rates ARE trading.

Everyone thinks a lot more carefully about a price when they actually have money behind it.

If I am not obligated to trade at this NYFR (or LIBOR or whatever rate) -- I could just say 5% every single day (or pick any number). It doesn't matter, its just a silly number. What do I care if its wrong? And unlike LIBOR, the NYFR number allows me to be anonymous-- so there is zero reputational risk.

What is needed as some sort of average / composite rate of actual unsecured lending... where money is actually being lent. Maybe JPM / BK (the two biggest settlement companies) might be able to quote average repo rates against general collateral (not trsy)... That wouldnt be perfect either, but at least it would be based on real transactions

Anonymous said...

Its rather amusing to have a Merrill analyst commenting about a competitor's liquidity / business mix.

Obviously this is a generalization, but if you look at all the sell side houses and major banks (and the GSEs)-- their Level III assets are often several times their stated shareholder equity. This is somewhat circular logic, since equity = Assets (including level 3) - liabilities. Its entirely probable that many of these companies have zero net shareholder equity.

Another big asset issue is "Deferred tax Assets", which are basically losses that the banks may be able offset against future earnings. There are loads of tax rules, but I think most of these tax loss carry forwards need to be used within 3 years?

Since many of these banks lost more in ONE YEAR than they made in the previous 6-8 years of "Boom time", what are the chances that the banks would make enough in the next three years to fully utilize these tax loss carry forwards? Not good...

And the next three years aren't expected to be "boom times"; if anything, the opposite is expected. Delevering, further write downs, layoff expenses, etc.

We haven't even started to assess the damage from CMBS exposure or the whole CDS mess.

So are these tax loss carry forward assets really assets? It seems a bit optimistic to put it gently. In order for these "assets" to count, the banks have to have earnings sufficient to be written off against. In short, a lot of these tax loss carry forwards aren't assets at all.

Once you discount the Level III assets (to reflect probable future write downs) and discount the Deferred Tax "assets" to reflect only what might be realized -- a lot of these banks have zero or negative share holder equity.

I think this explains why these banks are being charged junk bond like rates when they sell debt / preferred ... in essence, the bond holders own the company and the shareholders are nothing but accounting entries.

Anonymous said...

Good points Anon 8:30

I would also suggest that book value is an almost meaningless number when it comes to financial firms.

All the tables, desks, chairs, computers, phones, etc aren't worth even a fraction of the market value of the firm.

The biggest assets walk out the door each night. If they don't think they are going to get paid (what they think they are worth) -- they just don't come back the next morning.

Very few firms make much effort to institutionalize the knowledge they possess, and many employees feel their worth to the firm is greater if they hoard information.

The fact that Wall Street over-hires during booms and brings out the firing squad in times like now hardly gives the employees any incentive to even care what the long term value of the firm might be.

I mention all this because another phantom asset on many bank's balance sheets right now is good will. Basically, this is the amount the bank paid above the (probably inflated) book value of the firm they acquired.

That good will is the franchise value-- much of which is walking out the door in the people that are being laid off.

So in addition to discounting the stated values of Level III assets and Deferred tax assets, we also should be severely discounting the goodwill on most bank's books.

All a very lengthy way of saying: There is no book value to worry about.

Accrued Interest said...

Viking: Don't hold back, man! Just say what you mean! Anyway, I can't really respond because all you are saying is that CDS are a problem. You haven't said why.

On NYFR: I'm with you on the survey element. There are no perfect measures because where one bank could borrow will never be exactly where another bank could borrow. That being said, you can look at CP.

Citigroup CP for 90 days is 2.75%, or LIBOR +1.5bps. On my screen I also see Rabobank (2.50%), HSBC (2.58%) Calyon (2.65%). So there is a pretty wide range. These are offerings, so I can't assure that actual trades happen at those levels.

By the way, I got short XLF near the close on Monday, and covered yesterday. My cover wasn't near the bottom, if anyone cares.

Anonymous said...


You asked Viking to explain why the CDS market is a problem. This article from Asia Times Online lays out a case for big problems looming in the CDS market...

I'm still very new to the whole concept of Credit Default Swaps, so I found the article to be very informative. And the author definitely thinks the CDS exposure is a much greater problem for the financial system than subprime ever was.

I'd appreciate comments on the accuracy of this story from those of you who work in the CDS markets.

-Dave Wright

Accrued Interest said...

Dave: I actually think CDS are a big problem. Just not in the way a lot of people think. So I just wanted Viking to explain what particular problems he saw so I could agree or disagree.

On the Asian Times article... I've decided to write a full post on this subject since I think it deserves more coverage. I agree with most of the article, but I think he makes a few leaps of logic that don't really follow.

Remember two things: 1) It is usually the case that CDS have two sides, with a counter-party sitting in between. As long as both sides of the trade are solvent, the counter-party doesn't pay anything.

2) If a counter-party were to go BK, that's potentially a MAJOR problem. There is where the big risk is in CDS. We are seeing the impact with monolines right now.

Anonymous said...


I look forward to your post on the CDS situation.

Please bear with me on a few basic questions:

1) You said the MAJOR risk is if a counter-party goes bankrupt. I'm assuming you mean the issuer/seller counter-party, correct?

2) Would such an event make the value of their outstanding CDSs worthless? Would it force holders who were using the CDS as a hedge to sell/reduce the corresponding debt?

3) Who are the major issuers of CDSs (the articles mentions banks {IBs I guess} and hedge funds)?

4) Is there a way to profit from such an event? Short the banks (seems a little late - but maybe not)? Buy CDSs of the CDS issuers? (is that possible - who would be the counterparty?)

If this will be covered in the post, I can wait for the answers there.


Accrued Interest said...

Dave: Just look at what's happening with FGIC and XLCA (and will probably happen with MBIA and Ambac).

Banks were out there buying CDS protection against CDO positions. But if the counter-party (XLCA) is out of business, the CDS is worth a lot less. In this case, not worthless because the insurers have assets that the buyers of protection can make a claim on.

You don't want to think of CDS as being "issued." Think of it more like equity options. Say you owned a very large share of a particular public company. Maybe you once owned a business and you sold it to this larger company in exchange for stock. Say you are restricted from selling the stock (or there are huge tax consequences or some such.) So you buy some puts.

Now say that the put isn't on an exchange, but was executed directly with Bear Stearns. In March there was a very good chance you were going to lose the value of your puts!

But the pain would be limited to the replacement value of the put, right?

So how big a disaster it might have been depends on your gain in the put. Make sense?

Anonymous said...

Here comes kind of a rookie question. Are CDS and synthetic CDO positions the kind of thing that get designated a Level III asset? I'm also having a hard time with the sheer size of this market. Where do these positions appear on a balance sheet? Or are they by and large being held in SIVs? I guess what I'm driving at is this: Is it even possible to get a handle on counterparty risk? If the main CDS dealers are trying mainly to balance their risk positions and also profit from the premium spreads that they enjoy due to the opacity they maintain, they are dependent on the solvency of their counterparties. But it seems to me that there's no way they could really have any idea about the ability of their counterparties to make good. If I've got this right, then the Bear bailout finally makes sense to me.

Accrued Interest said...

Where a CDS position might show up depends on what it is. If its a well-traded item, it be Level I or II. If its less liquid, it be Level III.

Most non-broker financial insitutions are usually buyers of protection, not sellers. Also a CDS position may or may not have a positive value. If you bought protection on Lehman Brothers in mid-March at +450, that position would now have a negative value (the CDS currently trades at around +270).

And finally, if the counter-party is worthless, then the CDS is worthless.