By Carrick Mollenkamp | April 17, 2008 -
The Australian Newspaper -
ONE of the most im****tant barometers of the world's financial health
could be sending false signals.
In a development that has implications for borrowers everywhere, from
Russian oil producers to home owners in Detroit, bankers and traders
are expressing concerns that the London inter-bank offered rate, known
as Libor, is becoming unreliable.
Libor plays a crucial role in the global financial system. Calculated
every morning in London from information supplied by banks all over
the world, it is a measure of the average interest rate at which banks
make short-term loans to one another.
Libor provides a key indicator of their health, rising when banks are
in trouble. Its influence extends far beyond banking: the interest
rates on trillions of dollars in cor****ate debt, home mortgages and
financial contracts are reset according to Libor.
In recent months, the financial crisis sparked by sub-prime mortgage
problems has jolted banks and sent Libor sharply upwards.
The growing suspicions about Libor's veracity suggest that banks'
troubles could be worse than they are willing to admit.
The concern is that some banks do not want to re****t the high rates
they are paying for short-term loans because they do not want to tip
off the market that they are 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 is good for borrowers but could be very bad for the banks and
other financial institutions that lend to them.
No specific evidence has emerged that banks have provided false
information about borrowing rates, and it is possible that declines in
lending volumes are making some Libor averages less reliable.
But bankers and other market participants have quietly expressed
concerns to the British Bankers Association, which oversees Libor,
about whether banks are re****ting rates that reflect their true
borrowing costs.
The BBA is now investigating to identify potential problems.
Questions about Libor were raised as far back as November, at a Bank
of England meeting in which British banks, the firms that process bank
trades and central bank officials discussed the recent financial
turmoil.
According to minutes of the meeting, "several group members thought
that Libor fixings had been lower than actual traded interbank rates
through the period of stress".
In a recent re****t, two economists at the Bank for International
Settlements, a sort of central bank for central bankers, also
expressed concerns that banks might re****t inaccurate rate quotes.
A spokesman for the BBA, John Ewan, says the trade group is monitoring
the situation.
"We want to ensure that our rates are as accurate as possible, so we
are closely watching the rates banks contribute," Ewan says. "If it is
deemed necessary, we will take action to preserve the reputation and
standing in the market of our rates."
In a recent research re****t on potential problems with Libor, Scott
Peng, an interest rate strategist at Citigroup in New York, says that
"the long-term psychological and economic impacts this could have on
the financial market are incalculable".
Peng estimates that if banks provided accurate data about their
borrowing costs, three-month Libor would be higher by as much as 0.3
percentage points.
A small increase in Libor can make a big difference for borrowers. For
example, an extra 0.3 percentage points would add about $US100 to the
monthly payment on a $US500,000 adjustable-rate mortgage, or
$US300,000 in annual interest costs for a company with $US100 million
in floating-rate debt.
On Tuesday, the Libor rate for three-month US dollar loans stood at
2.716 per cent.
The Libor system was developed in the 1980s. Banks were looking for a
benchmark that would allow them to set rates on syndicated debt -
cor****ate loans that typically carry interest rates that adjust
according to prevailing short-term rates.
By pegging lending rates to Libor, which is supposed to represent the
rate banks charge one another for loans, banks sought to guarantee
that the interest rates their clients pay never fall too far below
their own cost of borrowing. Libor rates serve as the basis for
payments on trillions of dollars in cor****ate loans, mortgages and
student loans. They are also used to set the terms of more than $US500
trillion in "derivatives" contracts such as interest rate swaps, which
companies all over the world use to protect themselves against sudden
****fts in the difference between long-term and short-term interest
rates.
The global financial crisis has made it more difficult for banks to
package and sell all kinds of loans as securities, as well as to issue
bonds and short-term IOUs to investors. Increasingly, banks have
turned to the interbank market to borrow cash. But their mounting
losses on mortgage securities and other investments have raised fears
that a major institution could go bust. That has made banks
increasingly wary of lending to one another.
Such jitters have made many banks unwilling to extend loans to one
another for more than one week. As a result, the rates they quote for
loans of three months or more are often speculative, because there is
little to no actual lending for that period.
Citigroup's Peng believes banks could be understating even those
abnormally high Libor rates. He notes that the Federal Reserve
recently auctioned off $US50 billion in one-month loans to banks for
an average annualised interest rate of 2.82 per cent - 0.1 percentage
points higher than the comparable Libor rate.
Because banks put up securities as collateral for the Fed loans, they
should get them for a lower rate than Libor, which is riskier because
it involves no collateral.
By comparing Libor with that indicator and others - such as the rate
on three-month bank deposits known as the Eurodollar rate - Peng
estimates Libor may be understated by 0.2 to 0.3 percentage points.
In one sign of concern about Libor, traders and banks are considering
using other benchmarks to calculate interest rates. Among the
candidates are rates set by central banks for loans.
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