A worrying but informative article by Carrick Mollenkamp (Wall Street Journal, April 16th) about how “one of the most important barometers of the world’s financial health could be sending false signals.”
LIBOR, the London Interbank Offered Rate, is becoming unreliable because, so the article speculates, banks are sending in false reports. In other words, banks are providing misleading information to Reuters about their financial situations.
For those readers not famililar with LIBOR, it’s a measure of the average interest rate at which banks make short-term loans to one another. Banks typically set their lending rates at a certain “spread” above Libor: A company with decent credit, for example, might pay an interest rate of Libor plus one-half percentage point. A risky “subprime” mortgage may carry an interest rate of Libor plus six or more points. If you check the small print on your loan agreement, most likely it makes reference to the LIBOR rate.
LIBOR is set every morning for ten different currencies. Although the actual rates at which banks borrow from each other are known only to the lenders and borrowers, every morning before eleven o’clock coffee, London time, “panels” of banks send data to Reuters, on what it would cost them to borrow a “reasonable amount” in a designated currency. The USD Libor panel, for example, consists of 16 banks, including Bank of America, J.P. Morgan Chase, HBOS and HSBC. Reuters uses the reported borrowing rates to calculate Libor “fixings.” As Reuters’ spokesman is quoted as saying, “It is their data alone we distribute. Reuters is purely the facilitator.”
LIBOR is trusted implicitly in the financial community… or should I say, it was been truisted implicitly until late last year. The concern expressed in the WSJ article is that,
“Some banks don’t want to report the high rates they’re paying for short-term loans because they don’t want to tip off the market that they’re desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That’s good for borrowers, but could be very bad for the banks and other financial institutions that lend to them.”
The article goes on to quote Chris Freemott, a Naperville, Illinois, mortgage banker who depends on Libor to tell him how much his firm, All America Mortgage Corp, owes First Tennessee bank for a credit line that he uses to make loans. As Mr Freemott says, concerns about LIBOR’s reliability are “actually kind of frightening if you really sit and think about it.”
Of course, if this info makes the public newspapers, that means the cat is out of the bag. We can be sure that the banking community no longer trust LIBOR. Fundamentally, this translates into what we already knew: banks can no longer trust each other.
We live in interesting times.