Report: Libor Rise Is an Omen

Merrill Lynch says that the quick rise in the benchmark interest rate portends a dismal future for borrowers.

The recent rise in Libor rates is a dire warning to borrowers that interest rates won’t be dropping any time soon, according to a report issued by Merrill Lynch. The investment bank points out that the widely followed London InterBank Offered Rate currently shows that rates across various maturities are above their historic norms. “While there are many reasons for this, it can be largely attributed to heightened counterparty risk and, more recently, concerns about year-end funding pressures,” Merrill asserts in a new report.

Libor is the benchmark interest rate banks charge each other for short-term loans. The rate is based on what the world’s most creditworthy banks charge each other, so it is a starting point for the interest rates lenders charge less creditworthy borrowers — such as corporations. The rise in Libor is worrisome, emphasizes Merrill, because the rate is used to set the terms for numerous financial transactions.

To be sure, since the start of this week alone, 3-month Libor rates have jumped by 39 basis points even as the anticipated American federal funds rate — also known as the overnight indexed swap (OIS) rate — for a similar period fell by 9 basis points, according to the report. “This widening in the spread is partly due to ongoing counterparty risk concerns,” tied to the initial failure of the U.S. government’s bailout package, Merrill noted. However, the investment bank also notes it reflects expected funding pressures over year end.

Earlier this week, the U.S. House of Representatives defeated the $700 billion bank bailout bill that would have allowed the government to buy up toxic mortgage assets that are weighing down the balance sheets of banks. On Wednesday, the Senate passed its version of the bailout.

The Merrill report says that historically, the normal spread between 3-month Libor and OIS was close to 11 basis points. Since the current credit crisis began in August, however, the spread has averaged 74 basis points.

What’s more, since concerns about counterparty risk surged following the Lehman Brothers bankruptcy filing, it has averaged 166 basis points, and has now been above 200 basis points for four straight days. Merrill says a move below 166 basis points with sustained movement towards 100 basis points would indicate that the near-term crisis has passed. “However, we do not expect to see a move back to the 11 basis point norm anytime this year or next,” the author’s emphasized.

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