A LIBOR of Love

You may have heard some grumblings last week about a once-obscure, now well-known benchmark for interest rates. The London Interbank Offered Rate (“LIBOR”), overseen by the British Bankers Association (BBA), serves as the basis for interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). Trillions of dollars in floating rate corporate and mortgage loans are based on the level of LIBOR. That’s why when the three-month rate ticked up at its highest level since the height of the credit crunch in March last week, people started to talk.

Why should you care about LIBOR? Well, if you have an adjustable rate mortgage, you are impacted, because the interest rate on your loan probably keys off of the LIBOR rate. That means that your monthly payment rises when the LIBOR rate increases. If you are fortunate enough to be sitting pretty in a fixed-rate loan, there is another reason to think about LIBOR: the change in the rate may indicate that large institutions don’t quite trust each other and that the credit problems are not completely behind us.

Despite last week’s robust action in the stock market, there was one troubling note: the interbank cost of borrowing three-month dollars rose by its biggest daily amount since the credit crisis hit last August. The rate jumped almost 20 basis points last week alone -- the biggest weekly jump since mid-August -- as concern about the possible understatement of dollar Libor quotes by contributing banks surfaced and doubts emerged about the pace of further U.S. interest rate cuts.

To sum up the problem: banks are wary of doing business with one another and are hoarding cash, which is causing the credit market to seize up. The crunch in even short-term lending is a manifestation of a loss of confidence in the system. Until this is repaired, financial market pressures will remain and the effects of a contracting economy or some other event from commercial banks, the credit card industry or maybe the auction rate market, which is still not functioning normally, could catalyze another bout of de-leveraging. (It should be noted that the NY Attorney General has launched an investigation into the auction-rate market after it virtually collapsed in February when demand for the long term securities that price weekly or monthly dried up and Wall Street firms stopped supporting them.) Although these risks appear to be abating, to ignore them would be foolhardy. Sometimes being an investor truly is a LIBOR of LOVE!