Nov. 11 (Bloomberg) -- The drop in the premium banks charge for dollar loans above the federal funds rate to pre-financial crisis levels may indicate investors are underestimating risk again, according to Macroeconomic Advisers LLC.

The Libor-OIS spread has narrowed to the least since 2007, prior to the collapse of the subprime-mortgage market and the global credit rout, amid government support to the banking sector, the firm headed by former Federal Reserve Governor Laurence Meyer wrote. Investors may be under-pricing risk if the gap doesn’t widen as government support wanes, said former Fed economist Antulio Bomfim, who co-wrote the report.

“We’ve seen a decline in risk premiums larger than we would expect for this stage of the cycle,” Meyer, vice-chairman of Macroeconomic Advisers, said in a Nov. 9 interview. “We have to appreciate the signal from these spreads that suggests that the prevailing level is unsustainable. While we don’t think that suggests a dangerous reversal, certainly some reversal will be likely.”

The Libor-OIS spread measures the gap between the London interbank offered rate in dollars for three months and the overnight index-swap rate, or what traders expect the Fed’s target rate for overnight loans between banks to average over the term of the contract. The gap fell to about 0.1 percentage point this quarter, below the 0.11 percentage point average between December 2001 and July 2007. The spread soared to a record 3.64 percentage points in the weeks just after the bankruptcy of Lehman Brothers Holdings Inc. in September 2008.

Government Support

The British Bankers’ Association’s Libor determines borrowing costs on about $360 trillion of financial agreements ranging from home mortgages to corporate bonds. Three-month dollar Libor fell to a record low this month of 0.2725 percent. The Fed’s target rate for overnight loans has held unchanged at a range of zero to 0.25 percent since December.

Before programs began to be scaled back, the U.S. government and the Fed had spent, lent or committed $12.8 trillion to stem the longest recession since the 1930s. The Fed has begun cutting back some of its emergency aid to financial firms as part of its so-called exit strategy from a $1 trillion credit expansion.

“The fact that the Libor-OIS spread has so quickly retraced its movements since the onset of the crisis is not necessarily a good thing,” wrote Meyer and Bomfim in the Oct. 30 note. “After all, it is now a commonly held view that most risk spreads were abnormally narrow in the years that immediately preceded the crisis, likely reflecting investors’ overly optimistic assessments of underlying risks.”

Stocks, Gold

The Standard & Poor’s 500 Index of U.S. stocks, which tumbled 38 percent last year, has rebounded 62 percent from a 12-year low in March as government stimulus measures and record- low interest rates helped end a four-quarter contraction in the U.S. economy. The cost to protect against defaults on U.S. corporate bonds fell to a three-week low on Nov. 9 as finance leaders from the Group of 20 nations agreed to keep supporting their economies until a recovery is more assured.

Gold rose today for an eighth straight session in New York, the longest rally since early 2006, and reached an all-time high of $1,119.10 an ounce as a decline in the dollar sparked demand for the precious metal as an alternative asset. The U.S. Dollar Index, a six-currency gauge of the greenback’s performance, fell as much as 0.3 percent to a 15-month low before erasing the loss.

Narrow Spreads

In the years preceding the implosion of the subprime- mortgage market, declining measures of market volatility, narrowing credit spreads, and increased leverage triggered concerns by some economists and government officials that investors were under-pricing risk.

Federal Reserve Bank of San Francisco President Janet Yellen said in a June 2007 speech that while low risk spreads “may well reflect an environment wherein risk genuinely is reduced,” she was concerned that investors were underestimating risk.

The Fed said this week that U.S. banks kept tightening lending standards for companies and consumers last quarter, reinforcing the central bank’s decision to leave its benchmark interest rates at record lows for an “extended period.”

At the same time, the number of banks making it tougher to borrow diminished, the Fed said on Nov. 9 in its quarterly Senior Loan Officer survey. Demand for most types of loans weakened at a smaller number of banks than in the second quarter, the survey showed.

“The relatively normal level of the Libor-OIS spread may signal that the inter-bank funding market has healed, but we can’t be certain until the system is taken off the Fed’s medicine,” said Raymond Stone, principal at Stone & McCarthy Research Associates in Skillman, New Jersey, and a former Fed economist. “To date, lending and borrowing to other banks remains low. What happens when the banking system is effectively purged of the enormous redundancy of excess reserves is uncertain.”

To contact the reporters on this story: Liz Capo McCormick in New York at Emccormick7@bloomberg.net

Last Updated: November 11, 2009 11:58 EST