Money Market Black Swan

A Black Swan in the Money Marketin the Money MarketJohn B TaylorJohn B. TaylorStanford University

John C. WilliamsFederal Reserve Bank of San Francisco

Bank of Canada Conference on Fixed Income MarketsSeptember 12-13, 2008

The views expressed in this paper are solely those of the authors and should not be interpreted as reflecting the views of the management of the Federal Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System.

Turmoil in Money Markets

On August 9, 2007, money markets lurched into turmoil 5 0

6.0Percent

lurched into turmoil, with overnight rates swinging away from the Fed’s target rate

4.0

5.0

Effective Federal FundsT t F d l F d the Fed’s target rate

and longer-term money market rates

2.0

3.0 Target Federal Funds3-Month LIBOR

rising sharply.1.0Sep 06 Feb 07 Jul 07 Dec 07 May 08

A Black Swan in the Money MarketIn first half of 2007 In first half of 2007, spreads on 3-month inter-bank loans (relative to OIS) averaged 8 bp.

i h SD f 1 b1.0

1.2Percent

with a SD of 1 bp.

Beginning on August 9, 2007 d h t

0.6

0.8 3-Month LIBOR OIS Spread

2007 spreads shot up.

In the year since then, the 3 month Libor OIS

0.0

0.2

0.4

the 3-month Libor-OIS spread has averaged 67 bp., with a SD of 17 bp.

-0.22002 2003 2004 2005 2006 2007 2008

p

Libor: London inter-bank offer rate.OIS: Overnight indexed swap (proxy for average expected overnight rate)

Aim of Paper

Analyze and measure the roles of Analyze and measure the roles of counterparty risk and liquidity risk in term inter-bank lending rates during the term inter bank lending rates during the past year.

Evaluate effects of Term Auction Facility (TAF) on term lending spreads.( ) g p

Arbitrage-Free PricingAb i k d i bi i li h Absent risk and transaction costs, arbitrage implies that rates on term inter-bank loans should equal the OIS rate.

Example:Bank A loans Bank B $1 million for one month.

Bank A funds this loan by borrowing $1 million each day from overnight fed funds market.

Bank A hedges interest rate risk by entering in a overnight index swap, agreeing to pay the counterparty the difference between the contracted fixed rate and the average overnight fed funds rate over the next month.

In the past, arbitrage has kept the spread between Libor and OIS rate below 10 basis points.

Today, the spread is 80 basis points. What aren’t banks taking y, p p gadvantage of this opportunity?

Counterparty or Liquidity Risk?Counterparty risk: late Counterparty risk: late or non-payment of principal and/or interest.2.0

Percent

Liquidity risk: funds may be needed soon and hard to obtain elsewhere

1.2

1.6 Median (15 Banks)3-Month LIBOR OIS Spread

elsewhere.

Liquidity risk implies that banks are passing up

0.4

0.8

banks are passing up otherwise profitable opportunities to “preserve balance h t ”

0.0Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08

sheet.”

CD-OIS Spreads Show Same Pattern as Libor-OIS

CDs are a major supply CDs are a major supply of bank funding from outside banking sector and less affected by li idi bl

5.6

6.0Percent

liquidity problems.

CDs, term federal funds, d E d ll h

4.4

4.8

5.2

and Eurodollars show same pattern as Libor.

Libor has tended to be 2 8

3.2

3.6

4.0 3-Month CD3-Month LIBOR

Libor has tended to be below other term rates since March 2008, causing some to question

2.4

2.8

Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08

g qthe accuracy of Libor.

Money Market Turmoil in Europe

1.0

1.2Percent

0.6

0.8

US EU UK

3-Month LIBOR OIS Spreads

0.2

0.4

-0.2

0.0

2004 2005 2006 2007

EU: Euro Libor and OIS; UK: Pound Sterling Libor and OIS.

Indicators of Counterparty Risk

Credit Default Swap (CDS) rates

Libor-Tibor spreads

Libor-Repo spreadsLibor Repo spreads

Five-Year Credit Default Swaps Major U.S. Banks

200

240Bank of AmericaCitigroupJP Morgan

120

160

JP MorganWells FargoMedian

40

80

0

40

07:01 07:04 07:07 07:10 08:01 08:04 08:07

Strong co-movement in CDS rates across major commercial banks.

Yen Libor vs. Tibor

1 0

1.2

3-Month TIBOR 3-Month LIBOR

Percent

1.0

1.2LIBOR TIBOR Spread (Left Scale)LIBOR OIS Spread (Right Scale)

Percent Percent

0.6

0.8

1.0

.20

.25

0.4

0.6

0.8

0.2

0.4

00

.05

.10

.15

0.0

0.2

0.01996 1998 2000 2002 2004 2006 2008

-.05

.00


Tibor: Survey of Tokyo banks (4 of 16 in Libor survey).

Libor-Repo Spread as Credit Risk: Unsecured vs. Secured Lending

1 6

2.03-Month LIBOR Repo Spread3-Month LIBOR OIS Spread

Percent

1.2

1.6

0.4

0.8

0.0Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08

Liquidity Measures:Term Auction Facility (TAF)

Goal: restore functioning Goal: restore functioning of term inter-bank lending market, in part by reducing stigma associated with discount

i d b i 150

200

250

3-Month LIBOR OIS SpreadFed TAF Balance

Percent Billions of $

window borrowing.

Begun in Dec. 2007, expanded several times.1.2 0

50

100

150Total TAF Balance

28-day collateralized (discount window) loans.

0.4

0.6

0.8

1.0

Rate set in single-price auction (every 2 weeks).

Synchronized with dollar

0.0

0.2


Synchronized with dollar loans from ECB and SNB.

TAF Affects Composition, Not Size of Fed’s Balance Sheet

900Billions of $

700

800

TAF

Currency Swap

Primaryl

500

600Outright Holdingsof SOMA Repos

PDCFPrimaryCredit

ll

400

500

Jan 07 Mar 07 Jun 07 Aug 07 Nov 07 Jan 08 Apr 08 Jun 08

Econometric Evidence:3-month Libor-OIS Spreads

We examine effects of our three market-based measures We examine effects of our three market based measures of counterparty risk and the TAF on bank term spreads.

Theory is silent on timing of TAF effects on spreads, so we Theory is silent on timing of TAF effects on spreads, so we consider alternative specifications.

First specification: p

Libor-OIS = c + a*RISK MEASURE+ Σ5

i=1 bi*TAF AUCTION DUMMY(t-i)

Econometric Evidence: Libor-OIS Spreadsp(similar results for CD & Term FF rates)

(1) (2) (3)

Median CDS 0.56(0.07)

Libor-Tibor 4.58(0.45)( )

Libor-Repo 0.70(0.04)

TAF Auction -0 09 0 93 0 07TAF Auction(sum of coefs)

0.09(0.27)

0.93(0.18)

0.07(0.15)

Adj. R2 0.52 0.59 0.85

Sample: 1/1/2007 – 8/8/2008. Newey-West HAC standard errors in parentheses.

AR(1) Specification:Libor-OIS Spreadp(similar results for CD & term FF rates)

(1) (2) (3)




TAF Auction -0 06 -0 08 -0 13TAF Auction(sum of coefs)

0.06(0.05)

0.08(0.06)

0.13(0.05)

Adj. R2 0.98 0.99 0.98


Econometric EvidenceBased on three measures of term lending Based on three measures of term lending spreads:

Estimated effects of all three measures of counterparty risk have the right sign and are in most cases statistically significantmost cases statistically significant.

Estimated effect of TAF ranges between g-29 basis points and +145 basis points; negative estimated TAF effect is statistically insignificant in only 1 case (-13 basis points).

Robustness Analysis:Alternative Specifications

Post Dec-11 TAF dummy variable (Wu)

Include lagged lending spread and alternative TAF dates (McAndrews, Sarkar, and Wang)

Alternative Specification (Wu 2008)Post Dec-11 TAF Dummy Variable

Test whether Libor-OIS spreads are lower since announcement of TAF than before, after controlling for CDS spreadcontrolling for CDS spread.

Assumes TAF permanently affects spread.

Specification:Libor-OIS = c + a*CDS + b*TAF DUMMYLibor OIS c + a CDS + b TAF_DUMMY

TAF_DUMMY = 1 after Dec. 11

OLS Regression with TAF Dummy:Libor-OIS Spreadsbo O S Sp ads(similar results for other spreads)

(1) (2) (3)




TAF Dummy -0 03 0 29 0 06TAF Dummy 0.03(0.11)

0.29(0.04)

0.06(0.04)

Adj. R2 0.52 0.74 0.85

Sample: 1/1/2007 – 8/8/2008.Sample: 1/1/2007 – 8/8/2008. Newey-West HAC standard errors in parentheses.

AR(1) Regression with TAF Dummy:( ) g y3-month Libor-OIS Spreads

(1) (2) (3)

Median CDS 0.15Median CDS 0.15(0.08)

Libor-Tibor 0.55(0 26)(0.26)


TAF D 0 08 0 08 0 05TAF Dummy -0.08(0.01)

-0.08(0.00)

-0.05(0.02)

Adj. R2 0.98 0.99 0.98


AR(1) Regression with TAF Dummy:( ) g y3-month CD-OIS Spreads

(1) (2) (3)

Median CDS 0.54Median CDS 0.54(0.15)

Libor-Tibor 1.21(0 44)(0.44)


TAF D 0 04 0 14 0 14TAF Dummy 0.04(0.07)

0.14(0.15)

0.14(0.14)

Adj. R2 0.92 0.91 0.91


Econometric Evidence:Post Dec-11 TAF Dummy Variable

Based on three measures of term lending Based on three measures of term lending spreads:

Estimated effects of all three measures of counterparty risk have the right sign and are in most cases statistically significantmost cases statistically significant.

Estimated effect of TAF ranges from g-8 basis points to +44 basis points; negative estimated TAF effect is statistically significant in only 3 cases.

Alternative Specification based on McAndrews-Sarkar-Wang (2008)

Test whether Libor-OIS spreads change following TAF “events” (announcements, auctions), after controlling for contemporaneous change in CDS spread.for contemporaneous change in CDS spread.

Assumes TAF events have lasting effects on spreads (through lags of spread in equation).(through lags of spread in equation).

Specification:Libor OIS = c + a*Lag(Libor OIS) Libor-OIS = c + a*Lag(Libor-OIS)

+b*ΔCDS + d*TAF_EVENT_DUMMY

Results with Announcement Effects and Lagged Spreads

Libor-OIS Term Fed Funds-OIS

CD-OIS

Change in Median CDS 0 18 0 12 0 43Change in Median CDS 0.18(0.07)

0.12(0.08)

0.43(0.17)

TAF announcements -0.05(0 02)

-0.02(0 02)

0.02(0 04)(0.02) (0.02) (0.04)

TAF Operations -0.02(0.01)

-0.02(0.01)

-0.03(0.03)

Adj. R2 0.98 0.98 0.92


Results with Announcement Effects and Lagged Spreads

TAF d i h TAF announcements and operations have statistically significant effects on Libor-OIS spreads in MSW specification. p p

But, these findings are sensitive to choices of lending spread and TAF operations dummy:

Estimated effects of TAF announcements is insignificant using Term Fed Funds and CD insignificant using Term Fed Funds and CD spreads. Estimated effect of TAF operations is insignificant if TAF settlement dates are included in TAF operations TAF settlement dates are included in TAF operations dummy.

Reconciling ResultsTh id f i ifi t ff t f TAF t The evidence of significant effects of TAF announcements and operations on term lending spreads based on specification with lagged spread appears to contradict evidence from specification with post Dec 11 TAF evidence from specification with post-Dec. 11 TAF dummy, which indicates that spreads are NOT much lower after the introduction of the TAF.

Evidently, on days without TAF announcements or operations, spreads tend to rise, offsetting beneficial effects of TAF announcements and operationseffects of TAF announcements and operations.

These results are consistent with our first model, which i li th t TAF ff t d h t li d implies that TAF effects on spreads are short-lived.

Conclusion

Risk measures are economically and statistically significant predictors of term lending spreads. This is a robust finding.g p g

We do not find similarly robust evidence of an economically and statistically significant effect economically and statistically significant effect of the TAF on spreads.

Counterparty risk appears to be the Counterparty risk appears to be the predominant source of the extraordinary sustained rise in term lending spreads over the past year.p y

Money Market Black Swan

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