Declining Libor masks distrust between banks

Bloomberg

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The drop in the London interbank offered rate, or Libor, the benchmark for $360 trillion of financial products, to a record low masks a growing gap between the rates that the biggest banks charge each other for credit.

The difference between the highest and lowest interest rates banks say they pay for three-month dollar-denominated loans is near the widest this year, according to data compiled by the British Bankers’ Association, or BBA. The spread signals that lenders still lack confidence in each other, even though measures ranging from the so-called Libor-OIS spread to corporate bond sales show credit markets have recovered from the freeze caused by the Sept. 15 collapse of Lehman Brothers Holdings.

Still reluctant to lend

"It’s premature to judge that the credit meltdown is fully over," said Kazuto Uchida, chief economist in Tokyo at Bank of Tokyo Mitsubishi UFJ. "Banks remain wary of extending credit to each other due to strenuous concerns about counterparty risk."

Libor, a key rate, fell to 0.66 percent last week from 4.82 percent on Oct. 10. At the same time, the gap between the highest and lowest accepted quotes reported by 16 banks that contribute to the BBA for its calculation of Libor has averaged 7.6 basis points in May, according to Citigroup. That’s up from 4.9 basis points in April and 1.5 basis points in the six months before Lehman’s bankruptcy. It widened to 9 basis points on May 14, the most since Dec. 3.

While the spread, calculated by discarding the highest and lowest four quotes before determining the mean of the remaining eight, equates to about $76,000 of interest on a $100 million loan, it represents a growing proportion of Libor as the rate declines. On every day but 10 in the past three months, Royal Bank of Scotland Group, which is under government control, submitted the highest rate in the daily survey, according to Bloomberg data.

"The dispersion of Libor submissions seems to be exceptionally wide," said Marc Chandler, the global head of currency strategy at Brown Brothers Harriman. "There is potential for bifurcation of the financial system between banks perceived to be healthier than others."

Lending between banks started to freeze in August 2007, when losses linked to the collapse of U.S. subprime mortgages left financial institutions with billions of dollars in securities and financial contracts they couldn’t value. Losses and writedowns at the world’s biggest financial companies since the start of 2007 have grown to $1.47 trillion.

Concern about the deteriorating health of financial markets peaked in September when Lehman collapsed, Merrill Lynch was sold to Bank of America and American International Group was bailed out by the government.

Yields on Treasuries fell to record lows in 2008 as investors fled corporate bonds and stocks for the safety of government debt. Libor rose even as central banks slashed interest rates, jumping from 2.82 percent in the days before Lehman’s bankruptcy.

U.S. companies have sold a record $600 billion of bonds so far this year, up from about $500 billion in the same period of 2007. Rates on 30-year fixed mortgages are about 1.8 percentage points more than 10-year Treasuries, down from 3.27 percentage points in December. Morgan Stanley’s MSCI World Index of stocks is up almost 38 percent from its low this year in March.

While financial markets are improving, more than 60 U.S. financial institutions have collapsed over the past two years. In its latest quarterly survey of senior loan officers, the Fed found that more than 70 percent of respondents said bad loans will rise should the economy progress "in line with consensus forecasts."

Libor-OIS, which indicates banks’ reluctance to lend, fell to 0.45 percentage point last week, the lowest level since February 2008. Still, futures indicate the measure is about two years away from shrinking to 0.25 percentage point. That’s the level former Fed Chairman Alan Greenspan has said would be considered "normal."

The BBA asks member banks each morning how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages, throwing out the four highest and lowest quotes, and publishes them after 11:30 a.m. in London.

Libor would have been 0.67625 percent on May 22 when including the four highest and lowest quotes, above the 0.66 percent reported rate. JPMorgan Chase reported the lowest rate, at 0.59 percent, and Royal Bank of Canada the highest, at 0.94 percent.

The difference of 35 basis points was the most since Jan. 9, and up from 21 basis points a week earlier. The disparity averaged almost 58 basis points in the fourth quarter, according to John Ewan, a director of the BBA. Royal Bank of Scotland quoted the highest rate about 85 percent of the time since Feb. 19, according to the BBA.

JPMorgan, which has applied to repay the funds it borrowed under the $700 billion financial rescue package, typically quoted the lowest, data show.

"The disparity and the difference is really a signal to the market of who really wants to make some loans and who’s got the ability to make those loans," said Mark MacQueen, partner and money manager at Sage Advisory Services, which oversees $7.5 billion. "A lot of banks are just trying to hold on to what they have and not really make loans."

Libor came under fire last year amid concern that some banks were underestimating borrowing costs to avoid the perception they were in financial straits.Former Bank of England policy Willem Buiter described Libor last year as the "rate at which banks don’t lend to one another."