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Citigroup Research Note - Is Libor Broken? (pdf, 2008)

Via: Alea

Scott Peng, Chintan (Monty) Gandhi, Alexander Tyo

Special Topic: Is LIBOR Broken?

Summary points

- The current liquidity crisis has created a situation where LIBOR at times no longer represents the level at which banks extend loans to others. We believe that LIBOR may understate actual interbank lending costs by 20–30bp and recommend implementing a long 10-yr swap spread trade to hedge against a potential jump in LIBOR.

Something is rotten in the state of [LIBOR]
- William Shakespeare (with us taking some liberty)

Summary - LIBOR May Be Understating Real Interbank Lending Cost

We believe that LIBOR may understate actual interbank lending costs by 20–30bp and recommend implementing a long 10-yr swap spread trade to hedge against a potential jump in LIBOR. The current liquidity crisis has created a situation where LIBOR at times no longer represents the level at which banks extend loans to others.

Discussion - LIBOR’s Importance Extends Far Beyond Banks

LIBOR is by far the most popular floating-rate index in the world. Its importance has evolved far beyond its humble roots as an interbank lending rate. LIBOR touches everyone from the largest international conglomerate to the smallest borrower in Peoria: It takes center stage in every interest rate swap (whether it is explicitly part of the cash flow or not) and the great majority of floating-rate securities and loans. As such, the functionality and relevance of LIBOR is of primary importance to the global financial system. We believe the current liquidity crisis has damaged the interbank market, resulting in LIBOR sets that at times deviate significantly from real interbank lending rates. We discuss four factors that support this conclusion.