A Number Worth Watching: The TED

Once again with the caveat that I am most certainly not an economist, I will endevour to explain some of what is happening in markets right now in a way I hope makes sense to people.  I do this in part because I’ve been working to try to make things I’m learning over the months more accessible for those trying to figure out what’s going on.  Basically, I’d like to make things easier on people than they’ve been on me.  Also, I attempt this because I’ve overheard friends of mine discussing the Stock Market’s rise and fall as though they were indicators of anything accurate.  It isn’t, but that’s what we’ve largely been expected to believe.

In the particular case of this particular financial crisis, the number to watch is not the NASDAQ or the Dow.  It is the TED.  The who?  The T-bills to Euro-Dollar comparison rate.

In simplest terms, you can think of the TED as a benchmark of the willingness of banks to lend to other banks globally.  It’s based on a comparison between the current rate of interest on a Treasury Bill versus what’s known as the LIBOR, or London Inter-Bank Offered Rate (of interest, in other words).

The LIBOR is the rate at which banks typically lend to one another.  The TED is the difference between that rate and the T-Bills interest rate, which is considered to be a relatively stable benchmark.  As the TED goes up, things get bad.  Typically, the number hovers around 30 (or a 0.3% difference between the two).  Currently, it’s at around 465.  That basically means no bank is willing to lend to any other bank.  Until that number drops, our financial woes continue unabated, irrespective of the Dow’s current position.

So, that’s the bottom line of the TED and why we need to keep an eye on it.  As a basic explanation for why the rate is so high, think in terms of your own bank loans, like a mortgage.  I guess we’ll pretend the whole Subprime irresponsible lending thing never happened when we discuss this. . .

If you apply for a mortgage through FHA, you will be required to provide proof of employment because the bank would obviously like some proof that you will have the capital to pay back the mortgage.  If the amount of the mortgage relative to your income is fairly high or if you’re employment history is short, then there is a good chance you may now or in the near future have a problem repaying the loan.  If they give you a mortgage at all, the bank will probably enforce a higher interest rate on you.

The LIBOR works in roughly – very roughly – the same way.  It is the amount of interest imposed on a loan between banks.  In our current situation, there is a very good chance that some of the banks who have invested in risky enterprises may collapse.  And that’s a lot of banks, worldwide.  Moreover, those same banks are holding onto assets that might have otherwise been used like cash (like easily-tradeable capital) that are now worthless.  So, these banks have very little capital on hand to repay loans and are at risk of going belly-up before they’re done paying.

The relative risk of lending to these institutions has gone up dramatically.  At the same time, banks who might do the lending don’t necessarily want to be left with IOU’s instead of cash while they themselves are in danger of collapsing.  That’s still more incentive to raise rates.  Unfortunately, it now appears that rates have been raised to the point where no one can get a loan from anyone else.  Since lending between banks is the kernel from which most world economies draw capital, that means a frozen credit market equals a frozen economy.

So, there you go.  If you’d like to read more about the TED, you can check out this Wiki and this blog post, which I found to be quite instructive.