The Importance of the TED Spread

"TED spread" is a term given to the metric of credit default probability as measured by the difference between a major lending interest rate and the interest rate on a government's securities. For example, the TED spread can be calculated as the difference between London Interbank Offered Interest Rate (LIBOR) and U.S. Treasury bill interest rates. (econbrowser.com) The larger the difference between the two values, the greater the chance of a credit crisis or an existing credit crisis is. This article will discuss the TED spread in terms of the U.S. Treasury Bills and the U.S. Interbank lending rate.

To determine the intensity and level of a credit crisis, the TED spread between U.S. Treasury Bills and the Interbank lending rate of a same time period can be used. For example, the difference between the three month lending rate for both hen banks lend to each other there is risk; a quick and simple way this risk is measured is by use of the TED spread which compares federal reserve bank determined interest rate risk calculations with the interest rate of U.S. government Treasury Bills. Interest rate risk could be assessed by simply monitoring the movement of the Interbank lending rate over time, however the TED spread provides a more immediate solution to gauging market risk and is often published on financial websites and newspapers.

To illustrate the analytical benefits of the TED spread there are several financial and/or economic dynamics involved with what the number represents. These dynamics or financial relationships are composed of financial factors that include 1) Federal Reserve Bank decision making 2) perceived market lending risk on Interbank loans and 3) Spread or difference between two different interest rates.

Since the Federal Reserve Board assesses and determines the Interbank lending interest rates, it is logical to assume some economic analysis and risk assessment is incorporated into the interest rate. Secondly, since economics is not an exact science, there is a fractional factor of perceived and/or subjectively determined market conditions in the Interbank lending rate. Third, the difference between government loans and bank loans as measured by the Treasury bill interest rate and the Interbank lending rate illustrates a corresponding difference in risk, where the lower the difference, the lower the risk and vice versa.

Financial analysts, investors, economists, bankers and others refer to the TED spread to assess how the Federal Reserve Board judges commercial health of an economy. This in turn can lead to more conservative or liberal financial decisions based on other important metrics such as GDP growth, the unemployment rate, inflation etc. The latter of these metrics i.e. inflation is also important as the issuance of Government Treasury Bills is also tied to inflation.

Specifically, the higher the interest rate on Treasury Bills, the higher inflation may be due to either 1) oversupply of money within the economy 2) low demand for national securities of low risk and 3) the devaluation of currency, or a combination of all three. When the Treasury Bill side of the TED spread is not considered low risk, the TED spread loses some of its analytical capacity as the interest rate on Treasury bills is used as a stable low risk rate in comparison to the Interbank lending rates. If inflation is high and/or a Government is not well managed and insolvent, the value of the TED spread is diminished.

The TED spread is important because it is a simple and direct way to measure a number of things including how solvent the financial system's institutions i.e. banks are, and the availability of money i.e. liquidity within the economy. Since financial liquidity with low to average inflation is important for economic growth, a high TED spread of .5 percent or more is worth consideration in terms of investments, business development, economic performance and financial system functionality. During a financial crisis, such as that experienced within the U.S between 2007-2009, the TED spread went as high as 4.5% (bloomberg.com) indicating a very weak financial system, but a relatively stable Government.

A credit crisis includes a lack of credit availability, credit risk, low financial liquidity in an economy and carry over affects on the economy such as low mortgage originations, business loans, consumer loans and spending. Thus, a high TED spread indicator of 1-2% not only indicates weak macro-economic and financial market conditions (seekingalpha.com) but also micro-economic difficulties as they pertain to businesses and individuals.

To summarize, The TED spread is important in determining the possibility of credit default by financial institutions. Since several factors are built into the TED spread such as economic policy, government stability, inflation, market performance, and financial liquidity, the TED spread metric is useful in assessing the level of a credit crisis. Moreover, a credit crisis is likely to be measured by TED spread levels of 1% or higher assuming Treasury bills are in fact low risk government financial instruments.

Sources:

1. http://www.econbrowser.com/archives/2008/09/understanding_t.html
2. http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND
3. http://www.investorwords.com/5820/TED_spread.html
4. http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aPuOuvIiLNho
5. http://seekingalpha.com/article/45987-understanding-the-ted-spread

The Importance of the LIBOR

LIBOR is the acronym for London Interbank Offered Rate and this rate can vary from basis points in the tens to the multiple hundreds. The LIBOR is widely used as a financial benchmark for both consumer and business finances worldwide and is linked to the lending of over a hundred trillion dollars. (economistsviewtypepad.com) To put that in perspective, the U.S. economy produces around $14 trillion in value every year, making the LIBOR's influence very large.

LIBOR rates are set daily for 1 month, 3 month, 6 month and 1 year lending between United Kingdom banks. The reason LIBOR is important in regard to a credit crisis is because lending rates can affect the availability of capital in a financial system. The higher the LIBOR rate is, the greater the cost of borrowing funds for individual, real estate, equipment, individual or other loans becomes.

What happened to LIBOR during the credit crisis

When the most recent credit crisis began and the U.S. Federal Reserve Bank was lowering interest rates and making funds generally more accessible, the LIBOR continued to rise until October 2008, well into the credit crisis. (wsjprimerate.com) Essentially, this meant the British Bankers Association responsible for setting LIBOR rates were either unable to convince banks to lower rates or not fully cognizant of the implications high LIBOR has on financial markets. Unfortunately, the credit crisis was a big problem for the U.K. and the LIBOR did end up being lowered. In fact, the 1 month LIBOR rates dropped from over 3.8096% in October, 2008 to .3834 percent in January, 2009. (wsjprimerate.com)

The fourth quarter 2008 and 1st quarter 2009 drops in the LIBOR were due primarily to a recognition the credit crisis required liquidity to be alleviated. Dropping the 1, 3, 6 and 12 month LIBOR rates implied lower costs of financing new lending for banks. The reason LIBOR rates took so long to decline so long after the credit crisis started has to do with credit worthiness of banks. Since banks lend to each other with the risk of default, the risk of default rises during a credit crisis despite being a bank with good credit. Consequently, the default risk was built into the LIBOR rate until the credit crisis risk became higher resulting in a lower LIBOR.

Direct consequences of LIBOR and LIBOR Metrics

As a market indicator, a lower LIBOR indicates 1) acknowledgement of the magnitude of problem the credit crisis imposed on financial institutions and 2) the cost of borrowing money for financial institutions utilizing the LIBOR 3) measurement of perceived risk in the credit market and 4) assessment of progression and development within credit crisis. The causes of changes in LIBOR have been measured statistically by comparing the rate to other market lending rates. 

For example the TED spread is used to determine the difference between LIBOR and government securities yields of the same maturity. Other spreads used include the overnight interest swap rate for 30 day LIBOR, credit default swap rate to LIBOR spreads, and bank solvency risk to LIBOR spreads for measurement of credit and lending risk as a cause for LIBOR rates. (economistsviewtypepad.com) The course credit crises take is dependent on a wide range of factors both economic and financial.

A lower LIBOR has the effect of alleviating and spurring on economic and/or financial growth but is still only one of the variables in the equation of market and economic growth. Since LIBOR is not as connected to the government as the U.S. Reserve's Federal Funds Rate, the LIBOR is a more direct measurement of market conditions rather than Government linked response to financial market conditions. 

When LIBOR rates decline it may also be an indicator of where the financial markets are within a credit crisis. For example, since LIBOR reflects lending and default risk, a lowered LIBOR may indicate more creditworthiness between banks and a beginning to progressed resolution of the credit problems within the crisis. Moreover, a continually lowering LIBOR or bottoming of the LIBOR over time may also indicate the desire for financial growth combined with lower credit risk between banks.

Summary 

In summary, the LIBOR is an important banking-lending rate tied to a large amount of money worldwide. When credit and lending risk for banks rise, generally, so does LIBOR. However, when these risks become resolved, or are less important than the need for commercial growth, the LIBOR would decline. During the unresolved concerns of the credit crisis, LIBOR rose dramatically as commercial lending tied to the previous financial crisis devaluated. This happened even as the U.S. Federal Reserve has consistently lowered its lending rates. 

Evidently, the risks were still present throughout this period. It wasn't until the 4th quarter of 2008 and 1st quarter of 2009 that the LIBOR began to decline reflecting a possible resolution or bottoming of the credit problems and risks associated with the credit crisis. Nevertheless, in late January 2009, the three month LIBOR did experience an uptick indicating a possible continuation of credit risk.

Sources:

1. http://www.investopedia.com/terms/l/libor.asp
2. http://www.telegraph.co.uk/finance/economics/2815187/Liquidity-crisis-grows-as-Libor-rates-gap-hits-20-year-high.html
3. http://www.wsjprimerate.us/libor/libor_rates_history.htm
3.  http://tinyurl.com/6339trl (London Evening Standard)