LIBOR, the TED & OIS spreads are just as important, if not more important than the fed funds rate, because that's what sets rates globally.

the fed funds rate only applies to interbank lending for money center banks in the US. mortgages, credit cards, auto loans, student loans, commercial loans, etc. are typically based off of LIBOR.


LIBOR is the short-term rate for those participants not in the commercial banking system, e.g. mortgage brokers, stock brokers, hedge funds, investment banks, etc.


since the financial system is global, foreign banks have to use LIBOR rather than the fed funds.

what really kicked off the credit crisis was when LIBOR rates went through the roof, b/c banks were hoarding cash and not letting it into the global money markets. when that happens, interbank lending & the bond market shuts down.

and if that condition persists, companies will not get paid, they and their banks may go bankrupt, leading to bank runs, and further distress in the financial system.


risk in the system is measured by the TED Spread.

remember that 2 of the 3 components of interest rates are the risk-free, natural rate of interest, and a risk component.

also remember that all bonds are compared to a risk-free rate of return to determine its value.


the TED spread is simply LIBOR (short-term natural interest rate + the added risk of not having a gov't guarantee) minus a T-Bill rate (which is an approximation of the natural interest rate, aka risk-free, gov't insured, AAA cash). that difference attempts to quantify the amount of risk in the money market subsection of the bond market.

by definition, a high TED spread equals high risk, and makes the value of *all* bonds fall.

usually, the TED spread is a fraction of a percent, usually less than 0.5%. remember, all of these transactions are levered: they borrow money in the bond market to finance bond purchases. because of the leverage involved, only a few fractions of a percent can cause huge losses, or huge profits. if the cost of borrowing goes several fractions of a percent too high, the institution can become unprofitable quickly.

this is why low risk spreads are important to have a stable financial system.