This page is part of the homeplace advertisement-free web portal.

The value of the “Greenspan spread” is normally near zero -- about 6 basis points (0.06%). In July 2007 it shot up. It went to a new high of 106 (1.06 %) in Dec 2007. After Lehman filed for bankruptcy in Oct 2008, the measure soared briefly to 364 (3.64 %)!

BIG is BAD! Greenspan said in June 2008 that when “Greenspan spread” gets down below 25 basis points (¼ %) the banking crisis will be over.

This October 28, 2011 discussion is from here .

A key indicator of banks' wariness to lend this week hit its worst level since July 2009 according to Bloomberg data.

The spread between 3-month Dollar Libor (the rate at which banks lend Dollars to other banks for three months) and the overnight indexed swap rate (a lower fixed rate as interest rate swaps are considered less risky than cash lending), the Libor-OIS spread, is viewed as a measure of money market stress, tending to rise when banks perceive the risk of lending to each other is greater.

This 2-page St Louis Fed article is a good introduction.

As an aid to visualizing the Greenspan spread, consider the following.

The 1-month version of the 'Greenspan' spread, LIBOR minus OIS , has averaged 6 basis points from January, 2006 to August 1, 2007. During the Credit Crisis of 2007 and 2008, the maximum spread was over 100 basis points. (Source here.) Note that this is a one month version, while we select the three month version as the “Greenspan spread”.

Here is what should be an accurate reportage of the true (3-month) Greenspan spread. The time interval is late February to late August 2008.

The spread Greenspan says he focuses on as a measure of the willingness among banks to lend is the spread, or difference , between

1. the BBA LIBOR USD 3 Month value and

2. the USD overnight index swap, or OIS, rate forward 3 months.

We will call this spread the Greenspan spread. (Calling it LIBOR-OIS has a little too much potential for confusion, here.)

1. The minuend is collateralized only by the good faith and credit of the borrowing bank.

2. The subtrahend is less risky for the lender, being collateralized by a major currency -- euros, say.

These two rates vary similarly (between well under 1% per year to well over 5% per year) over time. So the difference of the two, Greenspan's spread , is very sensitive/volatile and quivers exquisistely as it indicates banking health.

On Feb 23, 2009 Greenspan said "Libor-OIS remains a barometer of fears of bank insolvency." "That fear has been substantially reduced since mid-October, but the decline has stalled well short of any semblance of normal markets."

The Greenspan spread belongs to a class of risk measures where the basic measure is a “BOR” (a bank offering interest rate). Some of these measures, such as the Greenspan spread and the TED spread, have been refined by subtracting another presumably-safer and presumably-similarly-varying rate. These differences, or spreads, are a sensitive measure of the lender's perception of the riskiness of the class of entities eligible for the loan.

The following table shows what the Greenspan spread might be. (There's a little confusion in the Media.) I think it's actually the last row.

A basis point is 0.01 of a percentage point. That is, a basis point is a ten-thousandth.

Greenspan: Watch this Key Spread http://moneynews.newsmax.com/streettalk/greenspan_libor_spread/2008/06/24/107133.html http://www.bloomberg.com/apps/news?pid=newsarchive&sid=amtoaXN6ltzY

“The worst is over in the financial crisis or will be very soon,” he says. In addition, “There is a reduced possibility of a large, intense recession.”

http://seekingalpha.com/article/80140-increased-libor-ois-spread-highlights-financial-sector-concerns

As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap [OIS] rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aCgIw40SBXAA

The price on one-year cross-currency basis swaps between euros and dollars reached minus 34.8 basis points today, the largest effective premium for dollar borrowing in swaps since the introduction of the euro in 1999, according to data complied by Bloomberg. The price averaged close to zero between 1999 and the start of the subprime mortgage market collapse in August. A negative price indicates investors are willing to receive reduced interest payments on euros they lend in order to obtain financing in dollars.

A Black Swan In The Money Market

John B. Taylor and John C. Williams (not Walter J. "John" Williams)

"The authors find no statistical relationship between the LIBOR-OIS interest rate spread and the utilization of the Term Auction Facility."

Following the unexpected leap in interest rates on the overnight loans between banks in early August 2007 and the subsequent turmoil in world money markets - a so-called "black swan" event, something that market participants had not seen before and therefore assumed could not exist - the Federal Reserve took several steps to stabilize the situation. In A Black Swan in the Money Market (NBER Working Paper No. 13943), John Taylor and John Williams demonstrate that increased counterparty risk between banks contributed to the rise in money market interest rate spreads. They find no evidence that the Fed's liquidity measures reduced these spreads.

The Fed made several attempts to improve conditions in money markets and thereby reduce the spread between term inter-bank lending rates, such as the three-month Libor (London Inter-Bank Offer Rates), and the overnight rate. An initial step, lowering the penalty on borrowing at the discount window, and thus bringing the discount rate below the prevailing Libor, failed to encourage banks to borrow from the discount window. Four months after the crisis had begun, the Fed introduced the Term Auction Facility (TAF), which allowed banks to borrow from the Fed without using the discount window.

Because the spread narrowed between December 2007 and the end of February 2008, it appeared that the TAF was working. Soon, however, the spread began widening again, and the renewed stress in the markets necessitated a host of new Fed actions and lending facilities. Since the financial turmoil continues to this day, Taylor and Williams analyze the initial phase of the crisis, specifically the 161 trading days between August 9, 2007 and March 30, 2008. They focus on three key money market interest rates: the target for the federal funds interest rate as set by the federal Open Market Committee, the daily effective overnight federal funds rate in the market, and the interest rate on the three-month Libor.

The "black swan" is perhaps most notable by the fact that from January through August 8, 2007, the standard deviation of difference between effective funds rate and the target was only 3 basis points, but from August 9, 2007 to March 30, 2008 the standard deviation was 20 basis points. Taylor and Williams suggest that the spreads between the three-month Libor and the Fed's overnight federal funds rate target increased dramatically starting in August and fluctuated erratically thereafter. During the year prior to August 9, 2007, the three-month Libor spread above the target federal funds averaged only 11 basis points with a standard deviation of merely a single basis point. Similar non-volatile changes in spreads between term rates and overnight rates were apparent for other Libor maturities and for several other countries.

Among the many explanations put forward for the marked increase in the Libor spread are "counterparty risk" (bearing in mind that inter-bank lending in the Libor market or term, Fed funds is unsecured); "liquidity risk," in which traders at one bank are reluctant to expose their institution's funds during a period in which those funds might be needed to cover the bank's own shortfalls; the notion that banks needed liquidity for purposes of their balance sheets in end-of-year financial reports; and expectations of future interest rate changes, especially declining rates.

To test these risk, liquidity, and expectation theories, Taylor and Williams developed a model that examined the Libor rate, the Overnight Index Swap (OIS) rate, and the accepted bid on the Term Action Facility (TAF). Comparing the behavior of these three activities and plotting their spreads allowed the researchers to separate out patterns of risk, liquidity, and expectations. For comparison and for supporting evidence, they also applied the same adjustment method to calculate the Libor spreads in the Euro, sterling, yen, and other currencies.

The researchers applied simple regressions to daily data to test how risk measures and liquidity measures like the Federal Reserve's Term Auction Facility affected the Libor-OIS spread. Five sets of regressions corresponding to different risk measures all emerge with highly significant results in both one-month and three-month maturity regressions. But, in stark contrast, the authors find no relationship between the TAF and the interest rate spread.

Nor should this be especially unexpected, say Taylor and Williams. They remind us that in assessing the effects of the TAF, it is important to note that it does not increase the amount of total liquidity in the money markets. Any increase in liquidity that comes from banks borrowing from the Fed using the TAF will be offset by open market sales of securities by the Fed to keep the total supply of reserves from plummeting. The actions are essentially automatic in the sense that the Fed must sell securities to keep the federal funds rate on target. For these reasons, Taylor and Williams conclude that counterparty risk is a key factor in explaining the spread between the Libor rate and the OIS rate, and the TAF should not have an effect on the spread.


-- Matt Nesvisky

http://papers.nber.org/papers/W13943
Copyright mediaforfreedom.com