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What Is Really Happening in the Credit Markets?

07 Oct 2008 15:30TraderF

There is a lot of uninformed talk about what is really happening with credit markets so I will try to shed some light of the current situation.


Firstly a little background.  Banks lend money to each other.  They in affect have accounts with each other.  Internationally the interest rate that banks lend to each other is set in London and called LIBOR. LIBOR simple stands for the "London Interbank Offer Rate", or in other words the interest rate that banks offer money to each other at.


LIBOR is typically a very orderly market where banks with surplus cash are able to lend it to other banks.  Over recent times the LIBOR market has become dysfunctional with each bank operating and very different LIBOR rates. Last night LIBOR rate varied from 3.95% from Chase to 5.00% at Barclays.  Also the rates that transactions are actually happening at are at unprecedented levels over the rate that the Federal Reserve will lend at.  The LIBOR rate blowout to 290 basis points over the Fed Funds rate.


The interesting thing is that LIBOR is still very low historically and this is due to Reserve Bank’s willingness to pump liquidity into the banking system.  It is not the interest rate itself that is the problem; it is the lack of agreement on LIBOR pricing and the willingness of banks to transact with each other. 


As Reserve banks pump money into the banking system, especially the US, they are vastly increasing the supply of their currencies.  This is leading to continued weakness in the currencies of countries with banking problems.  In the last few days there has been a flight to Yen and this is likely to continue.


There is a lot of alarmist talk in the media which is largely unfounded.  Clearly there will be a period where banks will be suspicious of each other and the key indicator of this period being past is to watch LIBOR spreads over the Fed rate.








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