The ballooning TED spread is a clear indication of the risk in lending to commercial banks and who could refute that sentiment with all the subprime mortgage exposure they carry. Why is the TED spread at it’s highest level in years?

To answer that, we’ll need a quick graph and an explanation to go with it.

TED Spread Explained

Before we get too far…let’s take a look at the chart…

The TED spread is the difference in yields between between the three month T-bill interest rate and three month LIBOR. The T-Bill rate is presumed to have no risk where the three month LIBOR identifies the risk lending to commercial banks.

If T-Bills are paying 4.50% and three month LIBOR pays 5.00%, the TED spread is 50 basis points(bps) or half of a percent. The TED spread varies daily like all rates / yields, but a typical range is from 10 and 50 basis points (0.1% and 0.5%).

Today’s TED spread (as you can see in the graph) is 236 bps…signaling to those that lending money to commercial banks even for three months is dangerous.

TED Spread Underlying Cause

When is a commercial bank to risky to lend to? When you don’t know how solvent they are, right?

Since virtually every bank both foreign and domestic is carrying some if not a lot of subprime, Alt-A, and Option ARM mortgage exposure on the books, investors know it’s something to shy away from or get adequately compensated for the risk.

If commercial banks can’t get investors to lend to them at a typical 50 bps spread, then they sweeten the deal. Up goes the TED spread. Today’s TED spread of 236 bps is where investors feel they are getting adequately compensated for the risk.

If it wasn’t for the mortgage crisis, that lead to real estate price declines, that lead to multiple bank failures, the TED spread would not be ballooning right now. Ironically, a high TED spread causes liquidity to dry up at a time when a systemic weakness in the banking sector can ill-afford it.

Good Luck!

PS: Here’s another post with links to TED Spread and Libor OIS charts, “Fed Chairman Bernanke Lowers Rate Here and Abroad”.

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