Friday, October 26, 2007

Measuring Risk Tolerance

One way to measure the fear or risk tolerance for lenders, is to compare the difference between the Fed Funds Rate and the 3 Month Libor Rate. Six months ago before the calamity in the sub-prime market came to a head, the difference in the two rates was 0.11%. This was the same difference 3 Months ago, 0.11%. However, a month ago the difference jumped to 0.45%. This increase showed just how great the uncertainty and fear lending institutions had. They are comfortable keeping what they have in order service the loans and holding requirements for loans they hold themselves. This change in the willingness to lend effected many of the "shadow" banking industry companies that do not have direct access to the Federal Reserve System. Today the difference in the two rates is still 0.23%, more than twice it was before the bright light of reality was shown on the many creative financial instruments created to manufacture greater and greater levels of financing. The difference has come down from its high, but it is still double what it was. Below is a speadsheet showing these rates. Look for the narrowing of this spread to gauge the built in concern and fear in the market. A widening of this spread, will mean that things are getting worse, and will foreshadow more rate cuts by the Fed.

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