Liquidity, inter-bank trust and the Ted Spread

The Ted spread is the difference between the 3 month T-Bill and the LIBOR rate. While the T-Billis a completely government backed bill, the LIBOR rate factors for the inter-bank risk. The Ted spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the rate associated with the LIBOR futures is thought to reflect the credit risk of banks. As the Ted spread increases, default risk is considered to be increasing, and banks will have a preference for safe investments. As the spread decreases, the default risk is considered to be decreasing.

Now lets just take a peak into what’s happened with respect to the Ted spread since January, 1987.

The highest spread was witnessed in Oct,1987. Surprisingly this was in the midst of another mortgage crisis. Mortgages on the wall street have been since the 1990’s the single highest traded securities. From 1990 the average Ted spread till march of 2007 was 0.50. It was only after analysts were hinting at the sub-prime and the crisis broke out did the Ted spread rise to over the 100 bps figure, it touched 1.98% in December, 2007. From 1997-1990 the spread was at an average figure of 129 bps, this when the crisis was a far cry from the sub-prime crisis of 2007. The gravity of this crisis has already been witnessed with Meryll writing down up to 88% of their CMOs and ADB writing of 90%. So, the question that arises here is are we assuming its over so soon? Or are we overly relying on the Fed? Or do we actually believe that banks have spun out of this crisis in a jiffy (6 months)?

Well honestly, I think not. The Ted spread still indicates that we are well in the midst of the crisis. In July,08 the spread shot 26 bps to touch 1.16%. Believe me it’s bankers who know best about the real situation that they are facing and thus will price the risk most accurately, and I believe that that is what they are doing. The Ted spread for the past one year since August,07 to July,08 has been at an average of 133 basis points. And, the spread is too high for us to believe that it’s all over.

The clear indicator that the crisis, in terms of write-offs, trust, and liquidity will be truly over only when the spread is less than 60 bps at least for an entire quarter. And obviously what we are seeing now is a clear indicator that a good proportions of the write-offs are still to come.

- Puneet Gulwani