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Term of the Week: TED Spread

Banking credit/liquidity-risk gauge measured by the difference in the interest rate on three-month T-Bills and that of three-month LIBOR

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While last week's term TIPS Spread sounded like a dip for asparagus spears, this week's term, TED Spread seems like it should measure the difference in the number of viewers CCN had before and after Turner Broadcasting unloaded it onto Time Warner (BTW, Ted Turner's Montana Grill has a mean asparagus dip, so maybe there may be a culinary tips spread, after all.) Alas, TED Spread has nothing to do with CNN; it's just another in a growing line of market sentiment gauges that you'll hear trumpeted as an indicator of our woes and then examined here (along with VIX, Vol. 5, No. 19, and the aforementioned and very tasty TIPS Spread, Vol. 6, No. 43). Now that every known and solvent government on the planet (which leaves out PMBA favorite Iceland along with any shadow governments) has injected mass amounts of cash into every market they could find—the Chinese on November 10 being the most recent example—and propped up every bank that could be propped, the TED Spread, a popular measure of panic in credit markets, is slowly receding. From a most fearful high of 463 basis points in October, the spread fell to 201 basis points right after the Chinese moved to pump over $500 billion into their economy, and as of this writing, the spread sits at 216 basis points. Although that is still stratospherically higher than the five-year average (the spread rarely exceeded 50-75 basis points from 2003 until August of this year, when it began its meteoric rise), it is a sign that credit panic is receding a little bit. So what is this TED Spread and how is it an indicator of credit risk?

TED Spread, literally, stands for Treasury Eurodollar Spread, for originally, it measured the difference in interest rates between the three-month Treasury Bill and the three-month Eurodollar contract, which is roughly equivalent to the three-month LIBOR rate. (For a basic discussion of LIBOR, the London Interbank Offered Rate, see Vol. 5, No. 36). You can go to any financial website, is particularly easy to use in this regard, to find out the current TED Spread or its component parts. To figure out the TED Spread, you simply subtract the one number from the other:

    TED Spread = 3-Month LIBOR Rate - 3-Month T-Bill Rate

The difference is expressed in basis points (BP). The reason for this is that, as in all spreads based on the difference between percentages, it is misleading to say that the difference between 3.00% and 1.50% is 1.50%, though you will often hear the difference expressed that way. In reality the difference between those two is 100%. Rather than saying the TED Spread is 100%, we extend interest rates two decimal points, then multiply by 100 and say it is 150 basis points:

    Hypothetical TED Spread = 3.00 - 1.50 = 1.50
    Hypothetical TED Spread = 1.50 * 100 = 150 BP

Expressing interest rate spreads via basis points affords observers the ability to see the actual difference and how much a spread is changing. Using percentages doesn't really tell you that. As another example, look at the following:

    Hypothetical TED Spread 1 = 3.00% vs. 1.50% = 100% Hypothetical TED Spread 2 = 4.00% vs. 2.00% = 100%

As opposed to:

    Hypo. TED Spread 1 = 3.00 - 1.50 = 1.50 * 100 = 150 BP
    Hypo. TED Spread 2 = 4.00 - 2.00 = 2.00 * 100 = 200 BP

The first comparison is useless because it doesn't show you the real difference between the two situations. Because the TED Spread has historically been less than 100 basis points in normal-to-booming economic times, its recent rise to 400 in early October tells you something. The question is what does it tell you?

To understand why the Spread is such a useful indicator of credit risk, you need remember the adage "no risk, no reward." You also need to look at TED's components: T-Bill rates and LIBOR rates. The former is the rate at which you lend money to the U.S. government. As explained in Volume 5, No. 36, the latter is the interest rate at which banks lend short-term, unsecured funds to other banks on the London money market. T-Bills are generally viewed as the ultimate in safety and liquidity. They are backed by the U.S. government, full, faith and credit, blah, blah, blah; they're as good a bet to be paid as anything.

In good and bad economic times, safety really doesn't pay that well. Risk pays better or costs more depending on which side of the transaction you're on. In good times, banks are also safe lenders and payers of debt. That's why LIBOR rates have traditionally been low, especially in good times. But in a financial crisis that is, at its core, about the solvency of banks, one would expect the rate that a bank expects to receive to lend money to another bank, one which might not be around in three months, to rise. (LIBOR tables bare this out.) Also, when economic times are tough, the Federal Reserve can be expected, generally, to lower target overnight interest rates, see Vol. 5, No. 36, which impacts the rates T-bills pay. As with all loans, it's all about getting the money you lend back. If you're a lender during a crisis, you want more back than most borrowers can pay. So, when the TED Spread moves higher, it means banks are charging other banks more to borrow, which indicates there is increasing credit risk in the market. If a bank which, after all, is in the money business, has to pay more, imagine what everyone else has to pay.

When the credit crisis began way back in 2007, and as banks became wary of making loans, LIBOR rates began to rise—skyrocket actually. At the same time, the Federal Reserve began chopping its targets month after month. Therefore the spread between the three-month component of each (TED, that is) began to skyrocket, as well. The spread between ultimate safety and relative risk did likewise. At TED's October peak, what that said was that in order to make loans to other banks worth the risk, banks needed an extra 400+ basis points over what a three-month loan to the U.S. government paid. Even with that premium, those same lenders may well have decided that T-bills were safer than lending their cash to borrowers that might go belly up, or they may have decided that they themselves might have urgent need for their case. So everyone flocks to T-Bills. The astonishing thing about that is that three-month T-bills have been paying pretty close to zero (they are essentially a mattress with an insurance policy at this point), yet that's preferred. There's your credit crunch.


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