Is the Credit Crunch Beginning to Soften a Bit — Signs From the TED and LIBOR-OIS Spreads
Economists have often looked to the TED and LIBOR-OIS spreads to identify the relative state of the credit squeeze. An increase in the TED spread or the LIBOR-OIS spread indicates a credit squeeze and a potential economic downturn.
TED Spread
The TED spread is the difference between the interest rate banks charge each other on 3-month loans (3-month London Interbank Offered Rate or LIBOR) and the interest rate on 3-month U.S. Treasury bills. The interest rates that the banks charge each other are typically higher as compared to the interest rates on the Treasury bills backed by the full faith and credit of the federal government. When the banks are concerned about a higher risk of default on the loans to other banks, they charge higher interest rates increasing the difference between three month LIBOR and Treasury bill rates or the TED spread.
At its peak during the Wall Street crisis the TED spread shot up to 464 basis points on October 10 from around 100 basis points during the first week of July 2008. It has since come down to 265 basis points last Friday Oct 31 following months of federal and worldwide intervention. It is still high from a historical perspective although it signifies some easing of the credit squeeze.
LIBOR-OIS Spread
The LIBOR-OIS spread is the difference between the LIBOR and the overnight index swap (OIS) rate. The LIBOR-OIS spread is considered a better measure of interbank worries or pure counterparty risk because it does not involve the safe havens transactions of the U.S. Treasury. An increasing LIBOR-OIS spread indicates banks charging higher interest rates to offset the risk of higher loan default.
Former Fed Chairman Alan Greenspan said in June that the LIBOR-OIS spread should serve as a measure for determining when markets have returned to normal. Historically, before August/September 2007, the spread was of the order of 10 basis points after which it shot up to around 100 basis points. It shot up dramatically after September 15, 2008 following the collapse of Lehman Bank. On Friday it narrowed 12 basis points to 242 basis points, the least since September 30. That is still very high by historical standards signaling a continuation albeit some easing of the credit squeeze.
The data indicate that we are not out of the woods yet as far as the credit crunch goes, although we may be out of the worst phase of it.
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