Why Libor Defies Gravity

Discussion in 'Wall St. News' started by THE-BEAKER, Sep 6, 2007.

  1. The Federal Reserve could cut short-term interest rates in the weeks ahead, but right now one key rate is going in exactly the opposite direction, something that could have a big impact on markets and the economy.

    That rate is the London interbank offered rate, or Libor. It is an important benchmark for everything from adjustable-rate mortgages in the U.S. to giant floating-rate bank loans taken out by global corporations.

    Credit-market turmoil has pushed the Libor higher, even as other short-term interest rates, such as the interest rate on Treasury bills, are falling.

    "Higher Libor rates affect the whole economy by tightening the budgets of borrowers large and small," says Lou Crandall, chief economist with Wrightson ICAP in New York. " It hurts corporate profits and tightens household budgets, too."

    The disjointed movement in Libor and other short-term interest rates underscores the turmoil that persists in money markets more than two weeks after central banks in the U.S., Europe and Asia sought to settle short-term lending by injecting massive amounts of cash into the global financial system. (How small investors are easing back into bonds. See related article.)


    • See complete coverage of the troubles in the credit markets.It also shows how financial trouble now ricochets around the world. Many European banks have been stung by exposure to U.S. subprime mortgages; some U.S. borrowers, in turn, could get stung by upward pressure on Libor rates set in Europe.

    Libor is an interest rate charged by banks for short-term loans to each other. It is set daily by a bank trade association in London. The loans can be in U.S. dollars, euros, British pounds or other currencies.

    U.S.-dollar Libor rates usually closely track the federal-funds rate, which is the overnight lending rate managed by the Federal Reserve. But the two rates are now parting ways, complicating matters for the Fed as it tries to manage the global credit crisis and pushing up many short-term interest rates for borrowers.

    For the first eight months of this year, the U.S.-dollar Libor rate for three-month loans between banks nudged between 5.34% and 5.36%. Yesterday, the rate hit 5.7%, marking the rate's fastest rise in several years. The Libor hasn't been this far above the base short-term rates set by central banks since the Enron and WorldCom collapses in 2001, according to the British Bankers' Association, which sets the rate.

    One reason the Libor is trading so high: Banks, many of them in Europe, have heavy commitments tied to struggling commercial-paper markets. They are reluctant to lend out dollars, and that is driving up short-term borrowing rates. Some are also worried that their counterparties in these trades, other banks, might be too weak to pay back the loans.

    The Libor could well settle in the weeks ahead, limiting the impact of the recent moves. Moreover, the impact is muted because other short-term interest rates, such as the interest rate on Treasurys, are falling. Treasurys are also used as a benchmark for many forms of borrowing. But if Libor rates don't settle down, it could have a large impact.

    When Chrysler and its finance unit borrowed $20 billion from banks in July as part of the auto maker's acquisition by Cerberus Capital Management, its loans were indexed to Libor interest rates. That means its interest costs go up and down as the Libor rises and falls, though some of the exposure could be hedged.

    Lou Barnes, partner of Boulder West Financial Services, a Colorado mortgage bank, has three Libor-linked mortgages of his own, valued at more than $800,000 in all. Because his own loans don't reset for several years, he isn't worried about being hit. But he says he does worry that many other U.S. consumers have fortunes tied to this interest rate that few understand.

    "They don't know how to pronounce it. They don't know what it means," Mr. Barnes says.

    According to HSH Associates, a New Jersey mortgage-information company, the interest rate on a three-year adjustable-rate mortgage taken out in 2004 and tied to the Libor could be more than a half-percentage point higher than a similar mortgage tied to U.S. Treasurys, whose yields have been falling. On a $200,000 mortgage, that is a difference of about $1,000 a year in interest payments, though many adjustable-rate mortgages include caps that limit how much interest payments can go up in any single year, softening the pain.

    A host of credit derivatives are also pegged to the Libor, as are many short-term commercial-paper loans used by banks -- $3 trillion globally. Financial contracts with values of about $150 trillion are indexed to the Libor, according to a paper published in May last year by Donald MacKenzie, a sociology professor at the University of Edinburgh.

    "There is no two ways about it, this is bad news for economic growth and for confidence in the financial system," said Teun Draaisma, head of European equity strategy at Morgan Stanley.

    The Libor became popular because in the 1980s the world needed a short-term rate on which to benchmark the costs for loans between banks. At the time, the interest rates banks charged other banks and big companies lacked a universally accepted basis. British bankers' stab at one took hold faster than others, and it is now a benchmark for many globally traded debt securities.

    --Cynthia Koons and Jon E. Hilsenrath contributed to this article.

    Treasury Prices Decline; 10-Year Yield at 4.558%

    Treasury-bond prices gave up most of their early gains yesterday, with longer-dated notes finishing lower, amid gains in stocks as data on manufacturing activity and auto sales last month beat expectations.

    The benchmark 10-year note fell 3/32 point, or $0.9375 per $1,000 face value, to 101 17/32. Bond markets were closed Monday for Labor Day. Its yield rose to 4.558% from 4.547% Friday, as yields move inversely to prices. The two-year note was up 1/32 point to yield 4.14%, while the bond equivalent yield on the three-month Treasury bill rose to 4.568%.

    In the absence of anything alarming in the most up-to-date economic reports, investors remain driven by the mood elsewhere in financial markets, said Scott Gewirtz, head of Treasury trading at Lehman Brothers in New York. "The market is thin, and people are trying to trawl through a lot of information, so they're taking their cue" from stocks, he said.

    --Emily Barrett

    Commercial Paper Hits a Volume Record

    Daily issuance volumes of asset-backed commercial paper hit a new high in the week to Friday, according to Federal Reserve data, a sign that the rush to sell ever-shorter-term-maturity debt amid the current credit crisis has yet to diminish.

    In the week to Friday, asset-backed commercial paper averaged a daily $90.6 billion, up from $88.6 billion the prior week. By comparison, average daily issuance last year was $51.2 billion.

    More than three-quarters of last week's issuance matures in one to four days, and only $938 million was issued in the 81-plus-days category. Last week's numbers were the highest since the Fed started keeping records on commercial paper in 2000.

    The rise in very short-term paper is a direct result of the current credit crunch, as investors have become reluctant to lend for longer periods because of concerns over issuers' exposure to the U.S. mortgage market.

    The asset-backed commercial-paper market has been widely used to fund purchases of higher-yielding, longer-term mortgage products.

    As a result, there is a pileup in commercial paper that matures over a short period.

    The most recent Fed data on this show that as of Aug. 24, there was $936 billion in commercial paper coming due by Sept. 14. There was also $509 billion in asset-backed commercial paper due by that date.

  2. It's a "proper" restoration of the risk premium that has shrunk out over the past several years.
  3. Rugby


    This is going to be a big story soon....sort of like "sub prime" was thrown around left and right before impact on market...

    We are talking about alot of U.S. mortgage re-setting off of LIBOR translating to 10% + interest rates...not good.
  4. There is absolutely no question in my mind this could be a problem. I am a commercial banker located in Florida. I price certain kinds of lines of credit off the 30-day LIBOR. This has been an extremely stable rate, and didn't budge more than 1 basis point for months. In six weeks, this rate has jumped 50 basis points, while all the other (treasury) rates have declined. Its unusual, and my customers have definitely taken notice.