The Reason Why The LIBOR Rates Have Been Partially or Completely Inverted
Steve Brown
October 11, 2007
What Exactly Are The LIBOR Rates?
LIBOR stands for London Interbank Offered Rates. The LIBOR Rates are benchmark interest rates set by an organization in the United Kingdom called the British Bankers’ Association (BBA). The LIBOR rates are used chiefly as a set of benchmarks for unsecured, short-term loans between the most creditworthy international banks. There are many different LIBOR rates with many different currency denominations. In the United States, the U.S. dollar-denominated LIBOR rates are published each business day in the Money Rates section of the Eastern print edition of the Wall Street Journal®.
In the American financial marketplace, the LIBOR rates play a key role as the index for many debt instruments and debt securities, including interest-only mortgages and other adjustable-rate loan products, and certain credit cards.
In the early 1990’s, financial markets around the world began using the LIBOR as an index for a wide variety of financial products, and that’s why the LIBOR rates are some of the most important market indices today. Many American banks index their loans and credit card products to the U.S. Prime Rate, but there’s a movement among banks to LIBOR indexing in lieu of indexing to the Prime Rate. Banks like the LIBOR rates because they change in response to current credit market conditions and are updated every business day. The U.S. Prime Rate, on the other hand, moves in synch with the Federal Funds Target Rate, which is usually reviewed by the Federal Reserve’s Federal Open Market Committee (FOMC) every six weeks.
Take a look at a comprehensive history of the LIBOR rates, and you’ll notice a pattern: the longer the term, the higher the rate. This spread makes sense, because interest rates tend to rise according to risk, and the longer a bank let’s another entity hold its money, the riskier the loan is.
Here are the average LIBOR rates for the month of January, 2007:
As you can see, the longer the term, the higher the rate.
However, in recent months, the LIBOR rates have been either completely or partially inverted. Yesterday, (Tuesday, October 10, 2007) the LIBOR rates were fixed with the following values:
So why are the 3 and 6 month LIBOR rates currently higher than the 12 month LIBOR rate?
If you guessed that it has something to do with the subprime lending mess which unfolded this year, then you guessed right. The American subprime mortgage crisis caused financial markets around the world to seize up. Bankers have been, and still are, nervous about lending -- even lending to other banks -- because bank managers aren’t sure which entities have exposure to subprime debt. When bankers get nervous, rates go up. In other words, the reason why the 3 month LIBOR rate is higher than both the 6 and 12 month rates is because banks are charging a premium for what they perceive as the riskier timeframe. In other words, the BBA feels that loans with a term of 3 to 6 months are riskier than loans with a term of 1 month or one year.
So, the big question is: when will the variance among the LIBOR rates return to normal? Eventually, the credit crunch that has been causing much pain in global financial markets will diminish and the LIBOR rates will return to normal. The FOMC cut the benchmark Federal Funds Target Rate by 50 basis points (0.50 percentage point) on September 18, which will help to bring calm to global credit markets. You may continue to come across sporadic reports of U.S. or European banks failing or faltering here and there. And it’s a pretty safe bet that subprime borrowers will continue to default on the unnumbered adjustable-rate mortgages out there that are resetting (a “reset” is basically a scheduled interest-rate increase.) But bank failures are far more common than most folks realize, and America’s housing crisis will likely be all but over by the time a new president replaces Mr. Bush in the White House. Banks, investors and other major financial institutions won’t be investing in risky mortgage-backed securities anymore, and the global financial system will heal itself.
LIBOR stands for London Interbank Offered Rates. The LIBOR Rates are benchmark interest rates set by an organization in the United Kingdom called the British Bankers’ Association (BBA). The LIBOR rates are used chiefly as a set of benchmarks for unsecured, short-term loans between the most creditworthy international banks. There are many different LIBOR rates with many different currency denominations. In the United States, the U.S. dollar-denominated LIBOR rates are published each business day in the Money Rates section of the Eastern print edition of the Wall Street Journal®.
In the American financial marketplace, the LIBOR rates play a key role as the index for many debt instruments and debt securities, including interest-only mortgages and other adjustable-rate loan products, and certain credit cards.
In the early 1990’s, financial markets around the world began using the LIBOR as an index for a wide variety of financial products, and that’s why the LIBOR rates are some of the most important market indices today. Many American banks index their loans and credit card products to the U.S. Prime Rate, but there’s a movement among banks to LIBOR indexing in lieu of indexing to the Prime Rate. Banks like the LIBOR rates because they change in response to current credit market conditions and are updated every business day. The U.S. Prime Rate, on the other hand, moves in synch with the Federal Funds Target Rate, which is usually reviewed by the Federal Reserve’s Federal Open Market Committee (FOMC) every six weeks.
Take a look at a comprehensive history of the LIBOR rates, and you’ll notice a pattern: the longer the term, the higher the rate. This spread makes sense, because interest rates tend to rise according to risk, and the longer a bank let’s another entity hold its money, the riskier the loan is.
Here are the average LIBOR rates for the month of January, 2007:
- 1 Month: 5.3201
- 3 Month: 5.3601
- 6 Month: 5.4014
- 12 Month: 5.4414
As you can see, the longer the term, the higher the rate.
However, in recent months, the LIBOR rates have been either completely or partially inverted. Yesterday, (Tuesday, October 10, 2007) the LIBOR rates were fixed with the following values:
- 1 Month: 5.11
- 3 Month: 5.2475
- 6 Month: 5.22125
- 12 Month: 5.08875
So why are the 3 and 6 month LIBOR rates currently higher than the 12 month LIBOR rate?
If you guessed that it has something to do with the subprime lending mess which unfolded this year, then you guessed right. The American subprime mortgage crisis caused financial markets around the world to seize up. Bankers have been, and still are, nervous about lending -- even lending to other banks -- because bank managers aren’t sure which entities have exposure to subprime debt. When bankers get nervous, rates go up. In other words, the reason why the 3 month LIBOR rate is higher than both the 6 and 12 month rates is because banks are charging a premium for what they perceive as the riskier timeframe. In other words, the BBA feels that loans with a term of 3 to 6 months are riskier than loans with a term of 1 month or one year.
So, the big question is: when will the variance among the LIBOR rates return to normal? Eventually, the credit crunch that has been causing much pain in global financial markets will diminish and the LIBOR rates will return to normal. The FOMC cut the benchmark Federal Funds Target Rate by 50 basis points (0.50 percentage point) on September 18, which will help to bring calm to global credit markets. You may continue to come across sporadic reports of U.S. or European banks failing or faltering here and there. And it’s a pretty safe bet that subprime borrowers will continue to default on the unnumbered adjustable-rate mortgages out there that are resetting (a “reset” is basically a scheduled interest-rate increase.) But bank failures are far more common than most folks realize, and America’s housing crisis will likely be all but over by the time a new president replaces Mr. Bush in the White House. Banks, investors and other major financial institutions won’t be investing in risky mortgage-backed securities anymore, and the global financial system will heal itself.
Print
Email
