LIBOR Explained

One of the things about crises is that formerly obscure terms all of a sudden become commonplace and of great interest to people.  LIBOR is one of these.  LIBOR stands for the London Inter Bank Offered Rate.  In essence, it is the rate at which banks lend to each other.  

If, for example, you come into your branch of Wells Fargo (WFC - Analyst Report) with a deposit of $1 million, it would be the intention of WFC to lend that money out to one of its customers.  But suppose that it doesn't have a good prospect right now for that loan.  At the same time, Citigroup (C - Analyst Report) has a long-standing customer which wants to draw $1 million on its existing credit line, but is a bit short of deposits at that moment.   Citi would then borrow the money it needed from WFC, which would normally be happy to do so, since it is better than having the cash sitting around idle in its vault.  The rate it is done at is LIBOR.  

There are 16 big banks from around the world which each day report the rate at which they are willing to lend to the British Bankers Association (BBA).  The group includes most of the familiar names, like Bank of America (BAC - Analyst Report), JP Morgan (JPM - Analyst Report) and Union Bank of Switzerland (UBS - Snapshot Report). This is done for a variety of time periods, but the most important is the 3-month maturity. The BBA throws out the four highest and the four lowest, takes the average of the middle eight, and reports it each day.  

The rate is important because it represents a bank's cost of funds.  Because it does so, it is logical for the banks to use this rate to determine what rate to charge you for a loan.  Thus, for example, most adjustable-rate mortgages are quoted at a rate of LIBOR + x%.

Under normal circumstances, Wells Fargo making a loan to Citi or JP Morgan for three months would be one of the safest things it could do with its money.  As a result, three-month LIBOR is normally priced just slightly over the yield on a 3-month T-bill, which is absolutely the safest thing a bank can do with its money (the government owns the printing press so it can always pay). The difference between these two rates is known as the TED (Treasury Euro Dollar) spread.

However, these are not normal times, and recently TED has become a minor celebrity.  Right now, TED is spread wider than the Grand Canyon.  The current spread is 4.24%; during times this year when the market thought the credit crisis was contained, it was down around 1.0%.  During normal times, it is usually less than 0.50%.

The implication of this is that WFC is not sure if other major banks like JPM will be around in three months, and as such has to charge a much higher rate to compensate for that risk.  However, right now the interbank market is just about dead -- not only are the rates abnormally high, but the volume of transactions is extremely low.  

As a result, the rates being offered are more hypothetical: "What would you lend for if you were going to lend?"  This can be seen in the spread between the highest and lowest rates offered among the 16 anointed banks (thrown out in any case).  Until the end of August of last year, when the current credit crisis started, the difference was rarely more than 5 basis points (0.05%), and rose to about 20 basis points during that period.  Recently, the spread between the high and low jumped to an astounding 175 basis points (1.75%).  

With Central Banks around the world throwing money at the banks, most banks seem to find it easier and cheaper to borrow directly from the Fed or the local equivalent than from other banks, and this could be seriously distorting LIBOR.  Not that it will matter when it comes time for your LIBOR-linked ARM to reset, though.

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