Turn of Year

A lot has been said about the turn of year premium this year. I'm probably writing this post a bit later than I should have. This would have been a more timely post a month ago or even three months ago. Alas.

First off, what is the turn of year premium? Well, in fixed-income-land, the turn of year premium represents the extra interest one charges to lend money over new year's eve. Generally this year-end rate is significantly higher, say 8% when libor is 5%. Sounds kinda silly right? It's just an artifact of financial regulations and having to shore up captial at the end of year when regulatory numbers are checked. A similar event happens at the end of every month.

Why is this important? It represents financial institutions willingness to lend to each other at the year/month end. This is a proxy for the financial institution's confidence in it's capital ratios. If a financial institution is under-capitalized it can mean all sorts of bad things for them from a regulatory perspective (not to mention a investor-base's perspective).

In the 1999-2000 turn of year, this overnight rate had been predicted to be ridiculously high. 3 month libor (the rate at which banks were willing to lend to each other for three months) starting in september started sky-rocketing due to the rate that would be charged for that one night. The overnight rate had spiked to over 200% annualized. Why? Y2K. People were afraid everything was going to fall apart when computers broke down due to the Y2K issue, so they were un-willing to lend over that evening (if everything falls apart, they may never get their money back). Well, the Fed made sure to flood the monetary system with loads of free cash and the turn of year disaster was averted (in fact the turn of year was quite cheap that year). The entry into the year 2000 passed with no disaster.

This year we had a similar spike in libor year-end rates. Not a computer bug that frightens the world this year though, something much scarier (at least from my perspective). Everyone's heard of the credit crunch occuring from sub-prime mortgages by now. Sub prime mortgage defaults and resets on stupid mortgages made for the past decade are catching up to banks and other lenders. Capital is at a premium because all the banks are having to write down so many of their assets (loans are assets to banks, if people are defaulting they're not worth as much). In fact banks are scared shitless that the sub-prime issue is going to spread to all credit products, and for good reason. As balance sheet capital becomes more dear to banks, our year end premium starts flying. Of course in the past couple weeks the Fed has pumped the economy full of cash again and it looks like we'll have another smooth transition into the new year.

These year end and month end spikes are a big deal in the fixed income world, especially in fixed income derivatives. The ramifications of interest rates ripple into all other markets though, as discount rates for futures (in equity, commodities, forex, etc) all depend on how the fixed income market is setting rates.