Option Investor
Trader's Corner

New Vocabulary

Printer friendly version

Why should you care what a bunch of bankers in the U.K. are doing? If you have an ARMs mortgage, you should care a lot. Your mortgage rate might depend on what those bankers decide.

How does that work, that bankers in the U.K. could have any input on mortgages in the U.S.? That's because some ARMs mortgages are tied to the BBA LIBOR rate, at least the USD version of the BBA LIBOR rate. Investopedia.com defines LIBOR as the London Interbank Offered Rate. In fact, the term is a trademarked one. Each day, the British Bankers' Association fixes a 3-month rate at which banks can borrow from other banks that are part of the London interbank market, with the BBA LIBOR the trademarked version. Individual banks may calculate their own Libor rates, the BBA site notes.

The BBA website says, " Central banks (such as the Bank of England, the US Federal Reserve and the European Central Bank) may fix official base rates monthly, but BBA LIBOR reflects the actual rate at which banks borrow money from each other." Watching the BBA LIBOR can provide information on how the world's financial markets are reacting to market conditions. According to Nick Hasell in a September 8 article for THE LONDON TIMES, BBA LIBOR rates are usually about 0.12 percentage points above the Bank of England's base rate, but that's been changing lately.

Member banks include familiar names such as Citigroup, Credit Suisse, Deutsche Bank, JP Morgan Chase Bank, Lloyd's TSB Bank and Mizuho International. The member list also includes the newly infamous Northern Rock, the bank that experienced a run on many of its branches on September 14 when it went to the Bank of England for help.

It might surprise many to learn that the U.S. as well as Canada, Switzerland and England use the BBA LIBOR as a reference or benchmark for short-term interest rates. Until recently at least, the world's best credit risks were able to borrow at or near BBA LIBOR rates while other borrowers might be required to pay several points over LIBOR.

Some would-be borrowers can't borrow at all. Recently, that list of turned-away borrowers grew, as did those who were not able to borrow at anything close to BBA LIBOR. In his September 5 Wrap, Keene Little pointed out that the actual interbank rate had soared much higher than the BBA LIBOR, something that was also being noted in the financial press. Compounding this problem was the fact that the BBA LIBOR itself has soared far above the Bank of England's base rate. According to that September 8 article by Nick Hasell, the LIBOR rate had jumped from its typical 0.12 percentage points above the Bank of England's base rate to 1.14 percentage points above that base rate. He quoted this as the largest gap in 20 years.

Central banks across the globe were using their open market operations to increase liquidity and bring loan rates back down toward their target rates. However, the increasing gap in the Bank of England's base rate and the BBA LIBOR, and in the BBA LIBOR and the points above that at which loans were actually offered were signaling trouble. They signaled that the central banks weren't being entirely successful in increasing liquidity because banks would rather hoard money than give out loans.

Lately, we've heard former FOMC head Alan Greenspan confess that the FOMC's efforts to lower rates had not been successful in lowering interest rates at the short end of the spectrum of U.S. treasuries, and something analogous was happening into early September with the BBA LIBOR and the benchmark rates of central banks. And that was scary.

Finally, on September 18, the day of our last FOMC meeting, THE LONDON TIMES reported that the three-month LIBOR rate had fallen to a three-week low. Articles in THE LONDON TIMES and on the BBA (British Bankers' Association) website make it clear that the move lower came only after a spike the previous day. The BBA's Chief Executive Angela Knight CBE noted that the Sterling BBA LIBOR rate was improving but was still significantly above the EURO and USD LIBOR rates. The decline was only temporary, with the BBA LIBOR rate jumping higher and then sinking again later this week.

Some financials may have already been hit. Hasell quotes Credit Suisse banking analyst Jonathan Pierce as saying that the mismatch in the BBA LIBOR and central bank base rates could result in downgrades of at least 10 percent in 2008 profit forecasts for some financials. It could cause worse problems than downgrades, too. At the time of that September 8 article, Pierce was already noting that both HBOS and Northern Rock, the bank that was to experience such trouble on September 13, were particularly vulnerable to problems engendered by BBA LIBOR's rise above the Bank of England's base rate.

In addition, banks might have to resort to their own depositors for their fund-raising efforts if they can't find funds elsewhere. That means that banks will compete more for depositors, and that means they'll have to offer higher rates on savings. That cuts into their bottom line another way, by leaving the banks with less profit from retail deposits. The slipping of LIBOR to a three-week low by September 18 and the sinking again on September 21 must have been a welcome development.

How can you find out what the BBA LIBOR rate is? It's published daily in Reuters. The BBA website also notes that it's made available by Thomson Financial, Bloomberg, Infotec and others. I go to thelondontimes.com for analysis of what's happening.

If you want information on how the rate is calculated or a source for news on the BBA LIBOR as well as historic rates, you can find that at the BBA website.

Trader's Corner Archives