SeriousBull

LIBOR rate a case of Price Fixing?

Tags: Credit + Economy + investing + LIBOR + Mortgages

LIBOR, the London Interbank Offering Rate, is broken and must be fixed. It seems that participating banks that set the LIBOR are reporting mysteriously divergent borrowing costs. UBS for example, which has reported $38 billion in write-offs related to the mortage crisis, has

also reported a significantly lower cost of borrowing than other banks with fewer or no write-offs.  Case in point, Lloyds TBS reported a 1.34% greater cost than UBS over the same three month period with no writeoffs according to Bloomberg News.  This pricing, even it accurate is flawed and causes a lack of confidence in LIBOR. Moreover, since banks reporting their borrowing costs have an incentive to report lower than actual costs to give the impression that their low cost of capital implies confidence in their bank the lack of confidence could lead to another freeze-up in credit. Accordingly, LIBOR must be reformed to reinstate confidence but doing so could have cataclysmic effects. It could for example exacerbate an already imperiled market that can little afford to have rates jump setting off a wave of new foreclosures and counterparty defaults. Stating what actual costs are is apparently a bad idea as well as few are doing it judging from the disdain and uproar.

So the question is how to reform LIBOR. On the one hand banks would like to keep LIBOR low. They have need to borrow themselves to replenish their reserve capital. On the other hand, banks would like LIBOR to rise to earn a greater spread on their loans. Perhaps since what their already doing with LIBOR amounts to nothing less than price-fixing, they will opt for a bifurcated LIBOR–a LIBORa for themselves set as an interbank low rate and LIBOR set for everybody else. Oh, what a tangled web they weave. 

Content and the idea for this article came from  an article written by Gavin Finch and Ben Livesey entitled: “Libor Cracks Widen as Bankers Struggle with Reforms (Update2)” from Bloomberg News.

LIBOR is the most important interest rate benchmark because some $350 trillion debt securities have their rates tied to it. Everything from Mortgage rates to Corporate loans, from  Leverage Buyouts to Derivative contracts are pegged to LIBOR. Banks and borrowers around the world have lost confidence at a time when a lack of confidence can least be afforded as it could lead to another credit freeze-up and only exacerbates an already bad credit crisis.

Intuitively, banks want to keep the rate low as many of them are borrowing to recapitalize their balance sheets to meet reserve requirements. However they would like to raise rates to earn a higher spread on loans they have made to boost profitability. As they are essentially price-fixing rates already, perhaps they will opt for a bifucated LIBOR–a LIBOR1 for interbank loans and a LIBOR2 for their customers. Oh, what a tangled web they weave!

May 27, 2008 - Economy, Markets