The credit freeze is thawing somewhat as as Dollar Libor Drops 17th Consecutive Day.

The cost of borrowing dollars for one month in London fell to the lowest level in almost four years as central-bank cash injections and interest-rate cuts worldwide showed signs of thawing the freeze in lending.

The London interbank offered rate, or Libor, that banks charge each other for such loans slid 18 basis points to 2.18 percent today, the lowest level since November 2004, and the 17th straight decline, according to British Bankers’ Association data. The three-month rate dropped 15 basis points to 2.71 percent, the lowest level since June 9, according to BBA figures.

Interbank rates have tumbled worldwide as central banks slashed interest rates and governments pledged as much as $3 trillion of emergency funds to kickstart lending. Australia’s central bank cut its benchmark rate by a bigger-than-expected 75 basis points to 5.25 percent today, joining policy makers in China, Hong Kong, India, Japan and the U.S. in reducing borrowing costs in the past week.

LIBOR Context

It is important to keep that move in LIBOR in proper context. Comparing LIBOR to November 2004 is not really a valid comparison. 1-Month Libor should be 10+- basis points the the Fed Funds rate, instead it is sitting 118 basis points above the Fed Funds rate.

Inquiring minds are also noting that the TED Spread, while recovering rapidly is still not back to normal.

Ted Spread

click on chart for sharper image
Chart courtesy of Bloomberg.

The TED spread is the difference in yields between inter-bank and U.S. Government loans.

Initially, the TED spread was the difference between the interest rate for the three month U.S. Treasuries contract and three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the three month T-bill interest rate and three month LIBOR. The TED spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another.

The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments.

Help For Existing Mortgages

Even though conditions are nowhere close to normal, the decline in LIBOR will take a tremendous amount of stress off existing LIBOR based ARMS. Here is a chart of 1-Month LIBOR courtesy of the Money Cafe.

That drop in LIBOR from 4.0% to 2.2% (assuming it holds) will reduce interest on many Pay option ARMs and interest only (LIBOR-based) ARMS by a whopping 1.8% compared to that recent spike. And with massive numbers of ARMs resetting now, that explains why the Fed and Central Bankers in general were scared half to death about that latest upward move in LIBOR.

Should LIBOR continue to drop to historic spreads there is still more relief coming for those in ARMs based loans.

Practical Example

Here is a practical example of how those in LIBOR based ARMs benefit from this. We are in an interest only LIBOR-Based mortgage now. The spread is 1.25% over LIBOR. The interest on our mortgage will be 2.2+1.25 or 3.55%. If LIBOR drops to the normal Fed Funds Rate + 10 basis points the interest on our mortgage will drop to 2.25-2.50%. And if the FED cuts another 50 basis points and LIBOR follows, our mortgage interest rate will fall to an amazing 1.75-2.00%. This is one such way those betting on deflation a few years back could have won.

Anyone in a LIBOR based ARM or a 1-year treasury based ARM will benefit mightily from this move lower in treasuries and LIBOR. Sreads will vary. Note that a mortgage rate at 1.25 over LIBOR is an amazingly low spread. Subprime spreads will be much higher.

If anyone was wondering why the FED slashed rates so far so fast, it was explicitly to take care of those in existing LIBOR based and 1-Year Treasury based ARMs. New mortgage applicants however, cannot come close to getting deals like these at such low spreads.

Mike “Mish” Shedlock
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