How much are banks paying to borrow? A new rate tries to find out

May.08, 2008 in Market Outlook

N.Y. Libor alternate tries to avoid London’s pitfalls

Still, upcoming interest rate is unlikely to show bank risks have improved

By Laura Mandaro, MarketWatch

Last Update: 7:31 PM ET May 8, 2008

SAN FRANCISCO (MarketWatch) — A New York-based measure of how much it costs
banks to borrow money will try to circumvent problems dogging Libor, the London
benchmark that sets rates for everything from adjustable-rate mortgages to
interest rate futures.

Successful avoidance of some pitfalls that have undermined bankers’ trust in
Libor, however, is unlikely to prevent ICAP Plc’s New York Funding Rate from
mimicking at least one of its London counterparts’ key traits. That is, a gap
with other interest rates that suggests borrowing conditions for the world’s
largest banks are still quite stressed.

“At this point, the U.S. index won’t make much difference, but it may be a good
idea six months from now,” said Brendan Brown, head of research at Mitsubishi
(UFJ) Securities International, in London.

Bankers point to a raft of other indicators, from currency forward rates to swap
spreads, to show that bank borrowing costs are still high even while other
measures of credit risk have fallen. That discrepancy has been a source of
nagging worry for investors and economists looking for proof that the worse of
the credit crisis has truly passed.

In fact, an interest rate that side-steps some of the problems that have recently
undermined investors’ trust in Libor may even show banks are paying higher rates
than shows up in Libor.

A month ago, Libor made its steepest five-day advance since August after concerns
emerged that some banks had been underreporting their rates, out of fear they
would be penalized if outsiders knew how much they were paying for funding.

Icap (UK:IAP), a London-based inter-dealer broker that specializes in handling
over-the-counter transactions like currencies and interest rates, is trying to
discourage banks from fibbing about their borrowing costs by making its survey of
40 global banks anonymous.

Plus, rather than ask banks for the rate at which they can borrow short-term,
unsecured loans — as the British Bankers Association does — ICAP will ask banks
for their estimates of what the going rate is for the average bank.

There’s some urgency among banks, borrowers and the Federal Reserve to know just
how costly it is for banks to tap the money market for their borrowings.

These funds are one of the main ways U.S. and overseas banks get capital for
their own lending activities. If their costs are running high, they are likely to
lend less, a headache for consumers and businesses that rely on flush conditions
at banks to fund new mortgages, new auto loans, student loans, acquisitions and
expansions.

And if the new measure does show Libor has been printing lower than the true cost
of interbank borrowings, a lot of consumers and businesses with loans tied to
Libor could get a nasty shock. It’s been estimated that loans and derivative
contracts totaling roughly $150 trillion (more than $20,000 for every person on
earth) are indexed or tied to Libor in some way.

In fact, the universe of financial instruments tied to Libor is so huge that some
bankers are nervous that any efforts to tweak the way Libor is collected could
make a bigger mess.

Libor “is extremely important,” said Terry Belton, head of fixed income strategy
at J.P. Morgan Chase. “We would probably create more problems by changing it in a
material way than we would solve,” he said.

Libor rises…

ICAP’s efforts to publish a new bank lending rate follows an unusual period where
Libor as well as other bank lending rates have frequently topped central bank
policy rates, meaning banks are paying more to borrow because of heightened
credit and liquidity risk

The difference, or spread, between the three-month U.S.-dollar Libor and the
effective federal funds rate rose to more than 80 basis points on Wednesday.
Usually, dollar-denominated Libor tracks closely with the fed funds rate. See
earlier story on Libor’s rise.
Click for Detail

By other measures, costs for banks’ borrowing needs have also been rising. The
spread between three-month Libor and overnight index swaps has been climbing
since February. What’s known among credit analysts as the BOR-OIS spread gives a
view of Libor that strips out expectations that central banks will raise or lower
rates.

These spreads “are all signs that there is stress in the market,” said Eoin
O’Callaghan, market economist for BNP Paribas in London.

Such signs of stress are worrisome for the Fed, which has $462 billion in special
lending programs to financial institutions as it tries to get money flowing in
frozen pockets of the credit market.

Notwithstanding efforts by the Fed and other central banks to “meet panic demands
for liquidity” by making more funds available to financial institutions, still
“many markets are not functioning normally,” noted Thomas Hoenig, president of
the Federal Reserve Bank of Kansas City, in a speech Tuesday.

In contrast to rates that reflecting bank costs, indexes that track perceived
credit risk and rates paid by corporations have been tumbling. Markit’s index of
high-grade, North American credit default swaps has fallen about 27% since
late-March. The spread between safe-haven 10-yield Treasury notes and bonds
issued by companies with Baa ratings, which indicate riskier but still
investment-grade companies, has also narrowed since mid-March.

… But not by enough?

Amid these concerns, other measures of short-term borrowing, such as the
over-the-counter market to buy currencies like euros or sterling for future
delivery, also suggest Libor just may not be high enough.

The British Bankers Association gets the Libor “fix” by polling global banks
including Citigroup’s Citibank (C), Bank of America Corp. (BAC), J.P Morgan Chase
& Co. (JPM), Barclays Bank (BCS) and Lloyds TSB Group (UK:LLOY) every day on what
they are paying for funds.

The group says it doubts its Libor panel banks are contributing to deliberate
distortions of the rate. Still, it has brought forward a review of how the rate
gets calculated. See related story.
Click for DetailAnd
banks may be paying more for their loans than Libor suggests for purely innocent
reasons.

It’s just not that liquid a market, bankers note.

Plus, the massive and surprise losses resulting from the U.S. housing market
collapse have created a lot of variation among financial institutions when they
try to borrow money. Banks that are light on funding or carry poor credit are
likely to pay a far higher rate in the forward currency market, for instance,
than the Libor panel would reflect.

“This is a problem that is temporary in nature and reflects the dislocation in
the financing market,” J.P. Morgan Chase’s Belton said. He predicts that as
central banks inject more money into the financial system “and as things there
improve, we’ll move back to a world where all banks in panel have similar
financing rates.”

Banks are likely paying more to borrow money, whether that’s reflected in Libor
or another indicator, simply because supply has dried up. Banks, mutual funds and
corporations that lend in the bank borrowing market are keeping more cash to
themselves.

“Confidence in and between banks has been dented significantly after the Bear
Stearns Cos. (BSC) episode. Investors and banks are reluctant to lend cash to
banks, effectively wondering who the next casualty will be,” said economists at
Societe Generale in a report.

In mid-March, Bear Stearns came close to collapse, causing fears of a run on Wall
Street.

“Also, money market funds, which are liquidity providers, continue to fear
redemptions and invest at very low maturities,” they noted.

New York fixing

Since the NYFR will be based on a survey, rather than actual transactions, there
still will be no way of telling if banks are giving an honest assessment of
borrowing costs.

“There’s not really an ultimate check on whether the rates banks are reporting
are the right rates,” said Brown of Mitsubishi Securities.

One thing that will change, however, is the time zone.

The British Bankers Association gets the so-called fixing of rates at 11 a.m.
London time, or about 6 a.m. New York time. That’s about three hours before banks
in the United States can start borrowing money in U.S. dollars, so may not
accurately reflect the price of costs facing banks trying to tap these dollar
markets.

ICAP’s planned NYFR rate instead will query banks at 9:30 a.m. New York time.

ICAP’s planned rate will also attempt to give a better view of what’s going on in
the market for dollar-based bank borrowing than one of its current measures,
eurodollar deposits. It gets this data from bid-ask spreads ICAP users provide
for these deposits and supplies it to the Fed, which publishes the bid rate daily
on its H. 15 statistical release.

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