While most people have a good understanding of what the “Prime Rate” for borrowing may be and understand that the Federal Reserve alters the Federal Discount Rate charged to banks in the United States which may alter the interest rates businesses and consumers may pay, fewer people have heard about the LIBOR rate which, in reality, plays an equally vital role in economic decisions.
This article shall discuss what it is and how it may effect businesses and governments in their economic decision making.
LIBOR is the reference for the interest rate at which banks lend short-term, unsecured funds to other banks on the London money market.
The London Inter-Bank Offered Rate was in the business news on a daily basis during the sub Prime Loan crisis of mid 2007 because, until recently, LIBOR had been rising to record levels relative to other benchmarks, like the Federal Funds Target Rate, which had been stagnant at 5.25% for months until September 17, when the Fed cut it to 4.75%. In fact, LIBOR was nearly half a percent higher than the Fed Rate at one point. (Note that LIBOR began falling just prior to the Fed's rate cut in 2007 and then fell 35 basis points, or .35% in the two days following the cut.)
If you were wondering why that credit crunch occurred beginning in August, 2007 when U.S. interest rates had been so stagnant, it had a lot to do with the Fed, but as much or more to do with LIBOR.
A substantial percentage of U.S. corporate bonds are pegged to LIBOR. According to Bloomberg, it was as much as much as 40% of them in early 2007, or $329 billion. The Bloomberg report implies that it was when international banks became increasingly concerned about all the losses (in hedge funds, U.S. banks and other financial players) resulting from bad bets on sub-prime mortgages (e.g., securities backed by them) in the U.S. that LIBOR started its rise.
As the fear of mortgage-backed securities increased so did fear of other high-risk instruments, which pushed LIBOR ever higher. That steady but inexorable rise made borrowing for issues pegged to LIBOR (which include mortgages) very expensive, and if you think about your own experience, when borrowing is expensive, you usually don't (or can't) do it, or in the case of sub-prime, variable rate mortgages, they get so expensive that holders can't pay them. At the same time LIBOR began its rise, the Fed Funds Target Rate sat at 5.25% and the Fed Discount Rate at 6.25%. Money was expensive all over. But the fact that LIBOR was so much higher than the Fed Discount Rate and Fed Funds Target Rate meant that no LIBOR banks wanted to lend money and be stuck with non-performing loans. Hence the credit crunch.
Who Uses LIBOR and How Is It Set?
If you want to actually know what the various LIBOR rates are at the moment they are published, you have to pay. There are 300,000 subscribers to LIBOR. The British Bankers Association (BBA) "fixes" LIBOR rates.
The reason LIBOR has to be fixed is that it is an average of particular banks (called Contributor Panel Banks) designated by the BBA. LIBOR is fixed on a daily basis, "just before noon London time," and there is a rate for the various short-terms available, up to a year. So you have one-month, three-month, six-month and 12-month LIBOR. Incidentally, the three-month LIBOR is the rate to which most sub-prime mortgages in the U.K. are pegged, and the six-month LIBOR is the peg for many U.S. mortgages. Thus the rise of LIBOR in 2007 had also been a contributor to the mortgage meltdown that began the mess in mortgage-backed securities and that led to the credit crunch.
In any event, BBA started its LIBOR fixing in the late 1980s "with the growth of syndicated lending and early developments in the derivatives markets." And today, "well over 20% of all international-bank lending and more than 30% of all FX transactions take place in London." (FX is short for foreign exchange or FOREX.) So all those currency and interest rate swaps are also lorded over by BBA LIBOR, at least those involving the following currencies: British Pound, Canadian Dollar, Australian Dollar, Euro, U.S. Dollar, Japanese Yen, Swiss Franc, New Zealand Dollar, Swedish Kroner and Danish Kroner. Who said the British Empire was dead?
Does it Matter for Business?
The recent and repeated problems with the United States markets including claims of self dealing and lack of accounting regularity are now repeated in the mortgage market in which clearly inappropriate lending occurred during 2007 on a massive basis. As pointed out in Congress during the World com scandal, foreign entities can only stomach so much of the increasingly prevalent lack of ethics and good business sense demonstrated by repeated market problems.
Consider: the United States has had booms and busts, often predicated on clearly inane economic thinking or pseudo pyramid schemes for many decades. We had massive inflation in the late 70’s; real estate boom and bust in the mid 80’s; and in the 90’s and early 2000 repeated stock market booms and busts with internet and then high tech. We had the Savings and Loan crises to demonstrate ineptitude in loaning on real estate in the 80s and now, early in the 21st Century, the United States suddenly confronts the collapse of the mortgage industry and discovers that just as stocks were radically overvalued in the late nineties, now real estate and its mortgages were vastly over valued in the early 2000’s.
All these repeated issues cause investors, both at home and abroad, to seek other indexes, markets and rate monitors to contrast with the American models. LIBOR is yet one more example of an international index now increasingly utilized in opposition to the one previously monopolized by the United States.
It will probably form an increasingly active role in setting rates for all businesses and more consumers as the years progress and the wise business person will get to know LIBOR as readily as Prime Rate in making economic decisions.