Economists John Taylor and John Williams recently wrote the research article, "A Black Swan In The Money Market," which discusses the jump in LIBOR rates and the effectiveness of the Federal Reserve's Term Auction Facility (TAF), we learned from website mediaforfreedom.com.
The National Bureau of Economic Research (NBER) abstract (Working Paper No. 13943) says, "At the center of the financial market crisis of 2007-2008 was a highly unusual jump in spreads between the overnight inter-bank lending rate and term London inter-bank offer rates (Libor). Because many private loans are linked to Libor rates, the sharp increase in these spreads raised the cost of borrowing and interfered with monetary policy. The widening spreads became a major focus of the Federal Reserve, which took several actions -- including the introduction of a new term auction facility (TAF) -- to reduce them. This paper documents these developments and, using a no-arbitrage model of the term structure, tests various explanations, including increased risk and greater liquidity demands, while controlling for expectations of future interest rates. We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads. The results have implications for monetary policy and financial economics."
The paper's introduction says, "On Thursday, August 9, 2007 traders in New York, London, and other financial centers around the world suddenly faced a dramatic change in conditions in the money markets where they buy and sell short-term securities. The interest rate on overnight loans between banks -- the effective federal funds rate -- jumped to unusually high levels compared with the Fed's target for the federal funds rate. Rates on inter-bank term loans with maturities of a few weeks or more surged as well, even though no near-term change in the Fed's target interest rate was expected. Many traders, bankers, and central bankers found these developments surprising and puzzling after many years of comparative calm."
"Rates on term lending, such as the Libor one- and three-month rates, seemed to have become disconnected from the overnight rate and thereby from the Fed's target for interest rates. It was as if banks suddenly demanded more liquidity or had grown reluctant to lend to each other, perhaps because of fears about the location of newly disclosed losses on subprime mortgages.... As we now know, that Thursday and Friday of August 2007 turned out to be just the start of a remarkably unusual period of tumult in the money markets, perhaps even qualifying as one of those highly unusual "black swan" events."
Taylor and Williams say, "The purpose of this paper is to document these unusual developments in money markets, assess various theories underlying them, and evaluate the impact of policy actions like the Term Auction Facility.... The renewed stress in the markets also gave rise to a host of new Federal Reserve actions and lending facilities. Though the financial turmoil persists, we view the introduction of these new facilities and actions as marking the beginning of a new phase of the crisis, where new policy responses will be evaluated and tested."
