The Impact of a New Term Auction Facility on LIBOR-OIS Spreads and Volatility Transmission between Money and Mortgage Markets During the Subprime Crisis

Abstract

During the subprime crisis, the U.S. Federal Reserve has been concerned about widening spreads between the overnight inter-bank lending rate such as the overnight index swap (OIS) and term London Inter-Bank Offer Rates (LIBOR). Among the tools it has used to counter the impact of the crisis, the innovative Term Auction Facility (TAF) has attracted a lot of attention. We investigate the impact of TAF on the LIBOR-OIS spread. We find that TAF has a clear initial effect on the three-month LIBOR-OIS spread but no sustained effect. In addition, TAF has no effect on the one-month LIBOR-OIS spread, casting further doubt in the usefulness of TAF on reducing risk spreads. Since the subprime crisis has also spilled across the interbank, commercial paper and jumbo mortgage markets, we further examine the lead-lag relationship among LIBOR-OIS, commercial paper and jumbo spreads and the volatility transmission effect among them. For the period before the crisis, we find that the three markets behave independently and do not influence each other. For the subprime crisis period, however, we find that multi-directional lead-lag relationships among these markets and time-varying volatilities across the three markets are significantly correlated.