What to Do About Libor

The rate on 3-month Libor has fallen 27 basis points over the last two days -- that's the biggest drop since the Federal Reserve saved Bear Stearns from bankruptcy in March -- and the TED spread has also fallen over the last four sessions. Are these signs that credit markets are thawing?

JP Morgan's Alex Roever says the equity injection program wasn't "a panacea for money markets or Libor" partly because both the supply and demand for interbank lending will be light as long as banks are worried about runs. That means holding onto funds will be of greater import than lending them out. But, overtime, funding pressures should likely ease, Roever said.

Most other analyst comments echoed the sentiment that the recapitalizaiton announcement would be the first step in a long unfreezing process.

But it's surprising that Libor hasn't fallen more, largely because the FDIC has guaranteed interbank lending free-of-charge for the next thirty days. And another measure of bank stress, the spread between Libor and Overnight Index Swaps, actually expanded today to 3.44 percent from 3.42 percent yesterday after falling for three straight sessions. (I don't want to put out a stat and immediately negate it, but it's also important to note that in a world where banks can get short-term money readily from the Fed, Libor loses some of its appeal as an indiciator of funding costs.)

With about $300 trillion worth of contracts dependent on Libor (that's $45,000 for every human being on the planet) and with the vast majority -- like mortgage interest rate resets and non-financial corporate funding -- not having anything to do with interbank lending, it's clear that Libor is massively important for the entire economy.

So what else can be done reduce short-term rates to historical norms?

Lou Crandall at Wrightson-ICAP points out that higher rates aren't just a signal of counterparty risk aversion, but also of an appetite for liquidity:

All sorts of market participants, from corporate cash managers to financial intermediaries, are scrambling to avoid the risk of being caught in a liquidity squeeze, which gives them a strong preference for overnight maturities.  Heightened concerns about counterparty risk may have been the major reason for the initial pullback from the term money markets last month, but investors' worries about their own liquidity exposure could make them slow to extend back out the curve even though the bank safety net has been strengthened.

And since there is no explicit method in the Treasury's recapitalization plan to force banks to restart interbank lending, other measures may need to be created if, despite Paulson's proclamation, Libor remains high. Crandall proposes one potential measure to tackle the supply issue: the creation of a bankers' bank by the Fed that would give short-term deposits to sounds banks in countries that had created solid safety-nets for their financial systems.

The Fed will wait for a while before trying anything radically new like this, but only for so long:

If LIBOR-OIS spreads don't start moving back toward pre-Lehman levels by the end of this month...the Fed may have to consider the creation of a new market entity to pull rate levels down.

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