On The Worthlessness Of LIBOR

Much has been said about Libor, Libor-OIS, TED spreads and other Libor-based  metrics, both here and elsewhere. It is no secret that liquidity conditions in Europe are at Lehman levels when looked at from a capital preservation and counterparty risk perspective, in terms of how much money the banks there have parked with the ECB. And yet the Libor as an absolute metric is far away from its all time wide levels seen in September 2008. Bloomberg's chart of the day provides a good reason for why Libor is not only no longer relevant, but why any reading for Libor (and potentially Euribor) no longer represents the true liquidity tightness experienced by member banks. As Bloomberg notes: "Banks have all but stopped lending to each other, driving transactions in the interbank market to the lowest level since August 1994 and undermining the validity of the suite of interest rates known as Libor. “The interbank market died with Lehman Brothers,” said David Keeble, head of fixed-income strategy at Credit Agricole Corporate and Investment Bank in London. “Libor is a strange beast, because the market that it’s based upon barely exists."

More from Bloomberg:

The CHART OF THE DAY shows loans between U.S. commercial banks have slumped to $153 billion from a peak of $494 billion in September 2008, the month that Lehman Brothers Holdings Inc. filed for bankruptcy protection. The London interbank offered rate is used to set interest charges on $360 trillion of financial products worldwide, according to the Bank for International Settlements.

“The interbank market died with Lehman Brothers,” said David Keeble, head of fixed-income strategy at Credit Agricole Corporate and Investment Bank in London. “Libor is a strange beast, because the market that it’s based upon barely exists. It’s going to take a couple more years to recover, and even then will never regain its former glory.”

Loans between banks have evaporated after central banks around the world pumped cash into the banking system by lending money in exchange for debt securities following at least $1.8 trillion of writedowns and losses by financial institutions as of May 18. U.S. commercial banks turned to the Federal Reserve for short-term borrowing after Lehman’s bankruptcy led to a collapse in trust amongst financial institutions, and the Fed opened its discount window to banks.

“There’s a lot more certificates of deposit that get issued instead of interbank lending, because they’re eligible if you want to turn them into cash more quickly,” said Keeble. “The whole structure has changed.”

The implications of this is that if even despite the massive deleveraging in liquidity needs vis-a-vis Libor that the overnight (and especially three month) funding rate has moved so aggressively over the past month, then one can imagine how much worse things would be if banks still had the $500 billion in the Libor market as of the peak, as opposed to the less than one third currently. With central bank backstops and the predominance of CD lending taking its place, it merely shows that even the smallest move in an otherwise useless Libor, likely has well over three times the implication it used to have previously. This means that the recent doubling in Libor is far more troubling than purists who only look at absolute levels in the metric and see a moderate move higher. As usual, when in doubt follow the money, and for the time being this means all open market operations by the ECB. Should the Discount facility usage continue to grow, it will be the purest indicator of just how bad things in Europe truly are underneath the surface.