LIBOR Reliability In Doubt

LIBOR has been spiking downward in the last few months as the sub-prime mess has unfolded (see WSJ article). Some feel this sharp downward move is signaling more trouble ahead in the financial markets. As it turns out, this downward spike may be signaling a different problem. Remember that LIBOR is the global interest rate that is calculated each morning from rate data supplied to the British Bankers' Association, the group that oversees the calculation of LIBOR. LIBOR has become the global interest rate of choice, and while being used to price many option and futures contracts, it is also increasingly being used to set rates for corporate debt and home mortgages, throughout the world. The problem is that the data being supplied may not be reliable. The system for setting the rate depends on member banks telling the truth about their borrowing rates. Given that some banks, especially those in trouble, are paying higher rates for the short-term loans they need to finance operations, they should be reporting these higher rates. It is speculated that some are not. Why not you say? Because these same banks do not want to signal to their investors that they are in trouble, such that they not only need additional cash, but they are being forced to pay higher rates, possibly due to decreasing credit quality.

What does it mean? Well, if true, borrowers are getting a good deal, but of course, the banks that are loaning to the borrowers are getting the shorter end of the stick. Estimates show that the actual rate should be as much as 0.3% higher. Should we care? Yes. As mentioned in the WSJ, an extra 0.3% on a $500,000 loan is about $100 a month more in interest. If adjustable rates move up to the "real" LIBOR rate, the impact on the US, including California, Nevada, and Florida, in particular, could be significant. Given that much of the current mortgage debt is also "hedged" using interest-rate swaps, various banks and agencies may find that anticipated delta moves and positions are not achieving the goal they are looking for - reducing their risk. To address the problems, banks are already looking for alternatives, with some considering the overnight Repo rate as a better gauge of short-term lending given that securities are put-up for collateral, making for a more reliable measure of rates.

To date, there is no hard evidence that this practice is occurring, or that it is nothing more than a reflection of the general decline in lending and data, but banks are concerned, and the BBA is looking into it. As reported at Bloomberg, the BBA is even going as far as to "... ban any member deliberately misquoting lending rates at daily money-market operations ...." A nice step, but possibly adding more fuel to the fire. What may be more damaging is perception. Having the LIBOR rate come into question may be just another message that the market does not need on its mind.