Swap Spreads, Bank Failures: Worst is Yet to Come

So despite the largest and most aggressive rate cutting campaign in history and despite a full alphabet soup of new, fancy liquidity measures, swap spreads continue to rise…

Can you say, “Uh oh! Something somewhere is about to go KABOOM?!”

Oh, and Libor traded at 2.81 percent today and that approaches the widest levels attained last August when the wheels came off Bear Stearns…

The difference between the rate banks charge for three-month dollar loans relative to the overnight indexed swap rate, the Libor-OIS spread widened to 78 basis points. That’s a lot and the worst level since May 2nd.

Five-Year Swap Spread Tops 100 on Risk Aversion: Chart of Day: “Interest-rate derivatives are showing that investors are preparing for another round of turmoil in credit markets amid renewed concern that the U.S. will have to bail out Fannie Mae and Freddie Mac.

``Risk aversion is continuing in the market,'' said Suvrat Prakash, an interest-rate strategist in New York at BNP Paribas Securities Corp., a unit of France's largest bank. ``These firms really may very well be closer to insolvency than we thought.''

The CHART OF THE DAY shows the five-year interest rate swap spread rising above 100 basis points in the past year ahead of the unwinding of structured investment vehicles, the collapse of Bear Stearns Cos., the seizure of IndyMac Bancorp Inc. and now mounting concern that the two-largest U.S. mortgage finance companies may need to be propped up by the federal government. The spread is the premium charged over Treasury yields to exchange floating for fixed-rate payments.

The U.S. plans to recapitalize Fannie and Freddie with taxpayer money if they fail to raise enough equity from private investors, Barron's said on Aug. 16, citing a person in the Bush administration it didn't identify. Treasury Secretary Henry Paulson, who on July 31 received authority from Congress to help the companies if needed, has said a bailout won't be necessary.

The five-year swap spread traded at more than 104 basis points late yesterday. The spread moved above 100 on July 17 for the first time since March, then retreated later in the month. The spread peaked at 116 basis points on March 6, the most since at least 1988, when Bloomberg began compiling data.

Swap spread movements usually reflect changing perceptions of credit risk and expectations of Libor. Swap rates are higher than Treasury yields in part because the floating payments are based on interest rates that contain credit risk, such as the London Interbank Offered Rate, or Libor.”

What? Why? How could this be?

Large U.S. Banks May Fail Amid Recession, Rogoff Says (Update2): “Credit market turmoil has driven the U.S. into a recession and may topple some of the nation's biggest banks, said Kenneth Rogoff, former chief economist at the International Monetary Fund.

``The worst is yet to come in the U.S.,'' Rogoff said in an interview in Singapore today. ``The financial sector needs to shrink; I don't think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job.''

Freddie Mac and Fannie Mae ``should have been closed down 10 years ago,'' he said. ``They need to be nationalized, the equity holders should lose all their money. Probably we need to guarantee the bonds, simply because the U.S. has led everyone into believing they would guarantee the bonds.''

Oh. Gotcha. The worst is yet to come…

Come on... did you REALLY think the greatest credit bubble EVER would end with JUST a 20% decline in real estate and stock prices?

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