What You Can Learn from LIBOR

Obscure Benchmark Can Hold Wealth of Clues; What the Neighbors Think

If you’ve ever owned an adjustable-rate mortgage, you might be familiar with LIBOR, the London Interbank Offered Rate. But have you noticed the extra attention this interest rate is attracting? To investors around the world, LIBOR is more than a mere benchmark for short-term interest rates. It’s a proxy for how global markets view the outlook for the U.S. economy.

Over There

About half of all U.S. adjustable-rate mortgages (ARMs) are tied to LIBOR levels.¹ The behavior of this interest-rate index determines whether ARM payments will rise, fall, or remain level each time the loans reset. Worldwide, some $300 trillion worth of loan contracts are tied to LIBOR. That comes to $45,000 for every man, woman, and child on earth.²

The British Bankers’ Association (BBA) actually publishes 150 LIBORs, covering 10 different currencies and 15 loan maturities ranging from overnight to one year.³ But the most closely watched is the overnight dollar LIBOR, which tracks the interest rates at which the most creditworthy London banks are willing to loan marketable sums of American dollars to each other overnight. Banks don’t like to leave money idle, even if only for several hours, so they tend to loan whatever surplus they have available to other banks that need to raise funds.

Once every banking day, traders at the leading banks report to the BBA the interest rate at which they could borrow money (they do not report the cost of actual transactions, only what rates are being “offered,” as the name indicates). To prevent any manipulation of the calculation, the association throws out the highest 25% and the lowest 25% of the quotes before averaging the rest to arrive at the benchmark rate.⁴

Money Hub and Hubbub

The overnight dollar LIBOR is important to U.S. investors because the rate is influenced by how London banks view the risk of lending American dollars. The rate generally goes up when the banks believe the likelihood of repayment is low.

In other words, LIBOR is an indication of the level of trust in U.S. finances. Because the U.S. financial markets have relied heavily on foreign capital, global opinions are important. It would be unlikely for stocks to sustain a prolonged rally when LIBOR is outside the world’s comfort level.

Why do London banks hold so much sway in money markets? London banks began to lend and borrow U.S. dollars (dubbed eurodollars when they trade abroad) after the pound failed to return to international currency status following World War II. This helped create a chain of events that eventually led London to achieve prominence in international money markets. Today more than 20% of international bank lending and 30% of foreign exchange transactions take place through offices of London banks.⁵

LIBOR is becoming an important indicator of investor sentiment. Keeping an eye on this benchmark can provide a good source of clues about the future.

1–3) London Review of Books, September 25, 2008
4–5) British Bankers’ Association, 2008

This material was written and prepared by Emerald Publications.
© 2009 Emerald Publications