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Wednesday, October 22, 2008

Q&A: What is LIBOR anyways?

If you've been reading the papers over the past month, you have most likely read about LIBOR--and probably even seen a graph of it year-to-date. That's because it's the indicator that "credit markets are frozen"--you've probably read or heard that phrase more often that you thought you ever would. (See for instance this article from

So what in the heck does all this mean?

I could just redirect you to the wikipedia article (, which begins as follow:

"The London Interbank Offered Rate (or LIBOR, pronounced /ˈlaɪbɔr/) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market)."

But let's break it down. First off, note that LIBOR is an acronym--London InterBank Offered Rate. Let's break that down letter by letter:

R for Rate: LIBOR is an interest rate, just like a mortgage rate or an interest rate on a CD you've got with a bank. With a mortgage rate, you've borrowed money, and you're paying that interest rate on the principal to whoever holds the mortgage (as we've learned over the past few months, that could in fact be holders of mortgage-backed securities all over the world, but let's not get into that now). With a CD, you've actually loaned your money to the bank, and they're paying you the interest rate on the amount you've invested (lent).

So who are the borrowers and lenders when it comes to LIBOR? It's an InterBank rate--it's an interest rate for interbank lending, i.e., for loans between banks. Why do banks lend to each other? Let's not get into that right now either.

What do we have left? An L and an O: L for London is something of an historical artifact--that the rate is set by the London wholesale money markets, i.e., the interbank lending market in London, b/c the British Banker's Association took the initiative to do so in 1984, and it subsequently became the benchmark rate for all kinds of finance-related stuff all over the world.

O for Offered means, as the wikipedia quote says, a measure of the rate at which banks *offer* to lend to the other banks. There is also LIBID, which is a bid rate instead of an offer rate--a measure of the rate at which banks are accepting deposits from other banks.

Why is it so important? LIBOR is a measure of banks' "cost of capital"--how much it costs them to raise funds to do business, or conversely how much they can earn on their excess cash. And it's also a measure of how much they trust that their fellow banks (their counterparties) will be able to repay these loans--when LIBOR spikes, as it has over the past month, it means that banks are very reluctant to lend to each other. It's clear why that is these days--banks are worried that any given bank that they lend to may not be around to repay the loan when it comes due (cf. Lehman, Bear, etc.)

That raises another point--how long are these loans for (more precisely, what is their maturity). There are actually multiple LIBOR rates--the most common ones are overnight, 1 month, 3 month, 6 month and 1 year. Currently bank are very reluctant to lend beyond the overnight maturity--they're worried about what could happen in the next month, the next 3 months, etc.

I'll close with one more reason why LIBOR is important, which is a bit more wonky. A striking feature of the Black-Scholes option pricing formula (that's for another day--see is that the interest rate that appears in it is the "risk-free rate," which is the rate at which the market participant can borrow and lend with no risk (of default). Sometimes this is assumed to be the US Treasury rate, but often banks who trade in derivatives markets use LIBOR as a proxy for the risk-free rate (see for example Section 4.1 of Hull,

Hence, with LIBOR so crazy and volatile, trading desks have difficulty pricing and hedging their derivatives books..

Finally, here is the BBA's website, which has much more on LIBOR, including historical data:

Friday, October 17, 2008

A couple newspaper notes: NYT/WSJ

I've saved a large number of newspaper articles over the past few months with the intention of blogging them, but very few have made it up. Esp with the finance-related ones, by the time I get around to going through the pile(s) of pulled-out pages I've stashed here and there around the apartment, the articles are too dated.

That said, I do still have a handful that I will get up..e.g., the good number references to Robert Moses that I've seen in the NYT over the past few months.

But for now wanted to do a short note with a couple observations about reading the paper (which is consuming a large proportion of my time these days, both in an absolute and relative sense (relative in the sense that it's "crowding out" book-reading..hence why I still have hundreds of pages left in "The Power Broker" and in "Death & Life of Great American Cities", even though I started both of them back at the beginning of the summer of Sam).

The two observations:

1) I am truly lamenting the demise of the stand-alone Metro and Sports sections in the print NYT. We had a system: Anj would take the front page, maybe Arts, maybe Business, which I'd catch up with in the following day. I'd start my day with the Sports and Metro--short and relatively non-heavy reading. And to tell the truth, I was spending more time with Metro over the past few months that Sports. A couple of the story lines that caught my attention over the summer:

(a) Brooklyn crime reports (e.g., the elevator assault in Crown Heights, the cabbie shot in the eye in Clinton Hill, the 9-year old shot and killed in the Weeksville Houses: )

(b) Transit-related coverage, ranging from newsy stuff like the proposed MTA fare hike, to features like the one on the Franklin Avenue shuttle, to stuff in between, like the article about "In Decade of Unlimited Rides, MetroCard Has Transformed How City Travels"--which included a distribution!

As of Oct 6, the Times folded Metro into the A section (and renamed it New York), and Sports into Business. So although the Metro stories are there, they're buried deep within the A section, and I don't get my hands on them til the following day...

2) Over the past couple weeks we're once again getting not only the print NYT delivered, but also the print WSJ. We were barely keeping up with the NYT (esp since I have a hard time recycling w/o at least flipping through) we've got a veritable avalanche of paper. I doubt we'll keep the WSJ beyond a short trial period, but it has been useful, as I've sorted out what, for me, is worth reading out of the Journal: choose one or two relevant articles out of Money & Investing; skip most of the front page section, but take a look at the op-ed pages; see if anything interesting in the Personal Journal; I skip Marketplace altogether.

Ironically I've found the op-ed pages to be what I spend the most time on, and even though it's often not stuff I agree with, they've often got stuff worth reading. E.g., right now I've got a healthy pile of pulled pages containing: "A Short Banking History of the US"; Gary Becker saying "We're Not Headed for a Depression"; a couple by their write Crovitz, one on VAR ("The 1% Panic") and one on JP Morgan ("He was more effective than Bernanke and Paulson combined"); a conservative economist writing on "Krugman Helped Us Understand Trade"; just yesterday, Karl Rove claiming "Obama Hasn't Closed the Sale", and their writer Daniel Henninger on "McCain's Katrina"; and today, William Poole on "Treasury Has No Authority to Coerce the Banks":

As you can see..way too much to keep up with..

Finally, one joint WSJ/NYT note: one reason I used to like getting the print WSJ was to read breakingviews on a daily basis, which used to get carried on the back page of the Money & Investing. But the WSJ dropped them in favor of their in-house "heard on the street", which is decent; but I still prefer breakingviews--which got picked up by the NYT, page 2 of Business!

Tuesday, October 07, 2008

Grossman followup: S&P in 1970s

One more note regarding Grossman's talk: he closed by saying it's embarrassing to hear commentators say that what's happening in the markets is unprecedented. As a case in point, he referred to the drop in the S&P in the mid-70s. He could find the exact numbers during his talk, but seems like he may have been referring to the period from Jan 1973 to Oct 1974, when the S&P dropped from a peak ~120 to a trough of 62: a drop of nearly 50%. Another remarkable fact: it didn't reach 120 again til July 1980. That was near the start of an unprecedented nearly 3-decade bull market in US equities.

Play around with ; but instead of looking at 1d or 1w, take a longer historical view.

Sanford Grossman / Deleveraging society

Last night got to listen to Sanford Grossman (
speak on the current financial/economic situation. It wasn't anything
groundbreaking, if you've been reading the paper over the last 12
months, but nevertheless, it was good to hear it distilled into a
couple main themes. Namely, his distillation is that what's happening
is (1) deleveraging everywhere, and (2) the return of risk premia.

His concluding thought was that while deleveraging
is happening at the level of financial institutions and individuals,
"the last shoe to drop" is the leveraged US economy itself--we've been
relying on foreign investors buying our debt, in order to finance our
current account deficit (trade deficit + fiscal deficit)..I googled
"current account deficit deleveraging" for a writeup--first hit was
this article from last week which summarizes it pretty well:

(Incidentally, 2nd hit was this "naked capitalism" post from late July,
which I think I'd actually skimmed at the time (maybe Krops pointed it
out to me?)...the rather worrisome title there is "Has deleveraging
even begun?"..I'm not sure whether he was trying to make the same point
as Grossman, but seems of a piece: )

Grossman's point: while the Fed/Treasury can bailout overleveraged
financial institutions or homeowners, as they get squeezed in this
"systematic deleveraging" (a phrase I saw in another article this
morning), it can't grow the economy, which is what's necessary to
deleverage our whole society. That will take a real readjustment of
our savings & consumptions patters, reallocations of capital and
labor--the sign of the latter being high unemployment.