No risk-free lunch

In these times of risk repricing, it seems that even the de facto risk-free rate can't escape. Libor is, of course, an index of large banks' offered interest rates for term dollar deposits held in London. In simple terms, if banks don't perceive other banks as presenting anything more than a negligible credit risk, then short-term Libor should price at around the Fed funds rate.

And that's how things were. But suddenly they weren't. The spread between one-month Libor and the Fed funds rate, which had been plotting a steady course, breached the 10-basis-point level in early August and was trading at more than 50bp a month later.

At first glance, this seems to suggest simply that banks are uncomfortable with the counterparty credit risk of other banks. But perhaps a more accurate assessment, according to some analysts, is that banks are worried by their own exposures arising from the liquidity lines they have granted to asset-backed commercial paper issuers and the like.

In other words, banks are turning away from the appealing interest rate they could earn on a three-month loan to another bank because they want to ensure they are able to take assets back on to their own balance sheet if required to. The surge in two-year US swap spreads, which had been trading at below 50bp in early July before rocketing to more than 75bp just two months later (prompting an inversion of the swaps curve) can be viewed as a consequence of banks' circumspection about balance-sheet capacity.

Still, at the end of last month there were tentative signs elsewhere in the financial markets that systemic risk concerns are abating somewhat. Ratings actions in the secondary market were certainly widespread, but corporates and banks have been tapping the bond markets, with buyers satisfied by tighter spreads than many had thought likely. Investors have also apparently been readying themselves financially for a buying frenzy focused on the $250 billion or more of leveraged loans that banks will need to start offloading soon.

Meanwhile, equity markets appear to be settling down. The Chicago Board Options Exchange's Vix index, which measures the market's expectation of 30-day volatility on S&P 500 index option prices, was trading below 20%, having touched levels of more than 35% in mid-August.

As is clear from this month's stories, many are coming to regard the events of recent weeks as something of a real-life stress test. Risks that had been latent on trading books while equity, currency and credit markets exhibited low volatility and liquidity abounded have suddenly started to assert themselves again. As one seasoned credit derivatives dealer put it: "Risk premiums are back, and it's like they never went away."

- Navroz Patel, Deputy Editor, Risk.

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