The TED Spread is the spread between the 3 month LIBOR and T-bill rate. It is viewed as an indicator of the overall health of the credit markets and economy, and around 0.5 points is normal. When the spread grows beyond 2 points, there is reason for concern, as this is an indicator that credit markets are freezing up, banks are not lending to each other and investors are fleeing to US government securities.
Q. So, today we get two news stories for one buzzword: this brings together the Fed results and the LIBOR scandal, right?
A. Yes it does. The TED Spread to the difference between 3 month LIBOR and US T-bills. It’s always been thought of as a critical measure of the health of the credit markets, and the overall economy. In fact, the Fed itself has often used the TED spread as a factor in how things are going, whether they need to add liquidity to the system, change rates, etc.
Q. So what kinds of a spread is normal?
A. When you look at the charts, you see that about a half a point spread is normal. When it gets to over 1, you’ve got some issues in the economy; over two, looking bad. During the crisis, it jumped to over four.
Q. So, just to be clear, exactly why did that happen?
A. Well, as the credit markets froze up banks had to pay more and more to borrow. Meantime, everyone fled into the safety of government securities, driving those prices up and interest rates down. So the gap got very wide.
Q. But maybe not as wide as it really should have been, correct? Isn’t that one of the big things the whole LIBOR scandal?
A. Right, as we discussed before, LIBOR is determined by what the banks say they can borrow at, not what they do borrow at. Looks like the banks were doctoring their submissions during the crisis, and understating what their real borrowing rates were. So even though the TED spread jumped to over four, even that probably understated the true difference. The crisis was even worse than it appeared.
Q. But crisis aside, this is a really important measure of the health of the economy, so what does it mean that, because of the way LIBOR is calculated, the TED spread might not be the accurate measure that we thought?
A. The idea that the TED Spread was essentially rigged is genuinely disturbing to a lot of folks. It’s been a foundational concept for a couple of generations of B-school graduates. And all this is definitely not going to help the banks as they try to fend off further regulation via the Volker, rule, etc… Given the political environment, this stuff couldn’t be coming out at a worse time.