And it gets worse. That increase in borrowing costs will spread to other parts of the global debt market, representing an across-the board threat to corporate, institutional and sovereign borrowers. If interest rates remain high and interbank lending remains tight, the credit crisis is not likely to recede.

This raises two key questions. Are desperate times prompting desperate measures? Is LIBOR being manipulated by banks that are trying to make their financial positions appear better than they really are?

If that’s the case, it’s one more reason the credit crisis will fester and spread undetected: The artificially low interbank lending rates removed a key “early warning” indicator, leading investors to believe the credit market was healthy when it actually wasn’t.

The Lowdown on LIBOR

LIBOR, or the London Interbank Offered Rate, is arguably the most important interest rate in the world. It is used to calculate the interest rates on hundreds of billions of dollars of corporate debt, mortgages and innumerable other loan products – including hundreds of trillions of dollars of derivatives.

It is important to understand that LIBOR is a “reference” rate, meaning it isn’t imposed on a borrower by any regulation or law. Developed in the middle 1980s, LIBOR is the benchmark rate banks use when they offer to lend unsecured money to other banks in the London wholesale money market.

LIBOR was created to make sure that banks that offer loans with “floating” – or adjustable – interest rates know just what their constantly changing cost-to-borrow actually is.

Lenders offering floating or adjustable rate loans typically charge borrowers a “spread” above LIBOR. When you hear: “Your cost on this loan is three-month LIBOR plus 5,” it means the lender is charging you the three-month LIBOR rate – plus an additional five percentage points. If three-month LIBOR is 4%, your actual rate is 9% (4% + 5% = 9%). If your loan re-sets in the future, it will do so based on the LIBOR rate that day – plus an additional five percentage points.

LIBOR is calculated for 15 different loan durations, ranging from overnight to a year, and is listed in 10 different currencies. For this discussion, we are focusing on only the dollar LIBOR rate, which is the rate, in terms of dollar borrowings, that banks theoretically charge each other when buying and selling dollars in the London market.

Each morning, “panels” of banks submit loan data to Thomson Reuters PLC (ADR: TRIN) in London, usually by 11:10 a.m. London time, and Reuters (a news, information, data and market quoting service corporation) calculates LIBOR, which is subsequently published each day by the British Bankers’ Association (BBA).

Subverting the System

That brings us to the current problem in the LIBOR market: As Money Morning has previously reported, there’s substantial evidence that LIBOR is being “managed.” This has been happening and the BBA is actively looking into it. In fact, several months ago, when the BBA announced it was speeding up its probe, LIBOR jumped.

The dollar LIBOR rate, or “fixing,” as it is known, is calculated based on the submission of quotes from 16 major world banks. The banks send in data as to what they paid, or could pay, to borrow from other banks at each maturity level. Reuters throws out the four highest and four lowest quotes, and calculates the average of the eight that remain to come up with the dollar LIBOR fixing.

If banks are seeking to charge one another higher rates, that’s telling us one of two things. Either:

• Banks don’t have excess cash to lend.
• Or they are unwilling to lend freely to other banks, which they fear are facing potential troubles because of bad loans, defaulted mortgages, and other pending hits to their capital and threats to their solvency. [Pending hits to capital could include anticipated higher foreclosure rates brought on by mortgage re-sets].

No bank wants to admit it is being charged a premium to borrow: That sends a bad signal. If a reporting bank submits data that shows its own borrowing costs are higher than average, it will very likely raise questions about that institution’s financial strength and stability – the kind of uncertainty that recently brought down such financial institutions as The Bear Stearns Cos. [now part of JP Morgan Chase & Co. (JPM)], and Lehman Brothers Holdings Inc. (LEHMQ).

So what might that bank do? Since the submitting banks providing data to Reuters are on the “honor system,” maybe this institution has an incentive to not submit its actual borrowing costs? Maybe this bank submits rates at which it could borrow – which it is permitted to do, by definition, under the submitting rules – if those rates are lower by virtue of only being a quote it received?

Maybe this bank – and the rest of its brethren – would like to keep LIBOR lower than the interbank rate should actually be, realizing that if rates rise, bad-loan exposure increases. And if bad-loan exposure increases, derivative exposure will escalate, too. What if U.S. ARM re-sets (based on LIBOR) bump up the interest-rate charges that already-strapped homeowners have to pay? What will more foreclosures do to already-battered bank balance sheets?

We already know the answers to those questions.

Since the interbank-lending markets here in the United States have not been freed up, the U.S. Treasury Department and the U.S. Federal Reserve have gone to extraordinary lengths to thaw out the frozen markets and get credit flowing across the economy. Included in their buckshot-pattern arsenal of misguided turnaround initiatives is one that forces the largest U.S. banks to borrow directly from the government. That initiative hasn’t helped because banks are simply afraid to lend to other banks because of the problem of toxic balance sheets and future loan-loss probabilities. Worst of all, no bank’s balance sheet has become a single bit more transparent. Nor will that ever happen if we do away with fair-value, mark-to-market accounting.

But, last Friday, at the same time Citigroup Inc. (C) reported November re-sets on adjustable rate mortgages will exceed $24 billion – which can only lead to further mortgage defaults – it was also revealed that some of the banks our government gave money to actually lent it to banks in London. Strange? Not really.

When JP Morgan, Citigroup and other big U.S. banks place money with London banks, specifically banks that submit borrowing cost statistics to Reuters that ultimately determines the LIBOR fixing, could it be that there’s more than free-flowing lending going on? Did the London banks lend any of the pittances that the U.S. banks lent across the pond?

By simple virtue of actually having more money to lend, and without any lending between themselves, London banks have the cover to say: “There’s money available to borrow, but we didn’t borrow any, but we could have borrowed and the cost to us would have been lower than it has been.”

So, they submit to Reuters the lower cost at which they could have borrowed and, presto, the LIBOR fixing is lowered.

Blueprint for a Turnaround

Desperate times, it has been said, require desperate measures.

While it is imperative that credit flows freely here and around the world, the desperate and manipulative measures that banks, the Treasury Department and the Federal Reserve are employing are the equivalent of the Air Force using a carpet-bombing campaign when it’s clear that a couple of smart bombs would do a better job. As a result, U.S. taxpayers are being bombed into a deeper, wider and steeper crater from which it will be very difficult – if not impossible – to climb out of.

There’s just not enough dirt to fill in the craters created by the repeated pounding of the errant policy bombs, as well as the disinterested and abetting regulation, unencumbered Wall Street greed and the profligate orgy of spending that’s come to define Main Street.

Fixing this massive problem – of which LIBOR is just an element – will take time. But we can start by taking all the lobbyists, ex-legislators and ex-regulators and their former staff members (and perhaps some current legislators who are serial enablers of such problems, and who enrichen themselves each time along the way) and burying them in the craters as we fill the holes in.

That rant aside, devising an actual fix for our problems starts by understanding just what it was that caused them. We can assign blame later. For now it’s far more important to stop the flood of red ink that’s washing down Main Street.

Understanding LIBOR and what’s really going on is critical to understanding the motivation and maneuvering of the players that have us headed for a worldwide financial Armageddon.

Source: Fears of Mortgage Rate Re-Sets May Fuel LIBOR Manipulation and Mask Deeper Banking System Problems

Editors Note: This is the ninth installment of an ongoing series in which retired hedge-fund manager R. Shah Gilani breaks down the credit crisis for readers.

According to the WSJ, there is a “rapid rise” in default rates on ARM mortgages,  mortgages that give borrowers with good credit several different monthly-payment options, reports. And a report by Citigroup says losses on ARMs may be “close to subprime” in some cases.

These mortgages, which are sometimes known as “pick-a-pay” or payment-option mortgages but are generically called option adjustable-rate mortgages, are turning out, in some cases, to be even more caustic than subprime loans, in part because the loan balance and the monthly payments on some loans is growing even as home prices are falling.

These loans have become the focus of investigations and a spate of lawsuits by borrowers who believe they were misinformed about the mortgages’ complicated structure.

“Buying real estate isn’t a popular view right now, says Floyd Brown, over at InvestmentU.com. “But that’s what being a contrarian is all about.”

Floyd thinks we could be closer to the end of the bear market in real estate, than the beginning. “This doesn’t mean we are out of the woods yet, but its time to start scouting for under-priced values in real estate, especially in the commercial sector…”

Floyd has found a way to buy $10,000 worth of real estate for $6,700. To find out more, click here.

Nor is it much of a surprise: Since the subprime crisis broke last year, we’ve repeatedly predicted the fallout would spread to such other markets as credit cards and even auto loans.

Citigroup Inc. (C), the third largest lender to Visa Inc. (V) and MasterCard Inc. (MA), said that the states hit hardest by the subprime fiasco – Arizona, California, Florida, Illinois and Michigan – experienced mushrooming levels of credit card delinquencies and defaults in the fourth quarter. In fact, those states accounted for two-thirds of the nation’s total credit card losses.

Evidence suggests that as adjustable rate mortgages (ARMs) reset to higher interest rates, consumers in these regions – and across the country – are relying more on their credit cards to finance such day-to-day living expenses as groceries and gasoline.

That’s not good.

If you don’t believe us, just ask the U.S. Federal Reserve. On the news that credit-card debt rose by $5.5 billion, or 7.1%, in January to $947.4 billion – dwarfing the 2.9% gain in December – the central bank announced that it’s conducting a formal review of the industry so that it can “better assess the current state of the credit card market.”

Like the subprime mess, as lending standards loosened on the heels of the 2001 mini-recession, consumer credit was extended beyond its viable limits. Credit-card issuers teased would-be clients – with marginal credit histories – with bargain-basement introductory interest rates, only to sock them with a much higher rate a few months later.

And now that the higher rates have kicked-in – and on nice, fat balances, too – people are struggling to keep up with their bills under the strain of an economic downturn.
Analysts widely expect the situation will get worse before it gets better. And they’re likely right. But this credit-card fiasco probably won’t have the cataclysmic, far-reaching effects that defined the subprime debacle. As a result, there are opportunities to profit.

Maxing Out on Credit

The credit crunch was, of course, sparked by high levels of defaults on subprime mortgages extended to people with shaky credit histories. And because banks pool mortgages together and sell them as investment vehicles – called mortgage-backed securities (MBS) – investors were left holding worthless paper (and massive losses) when the mortgages went belly up.

Consequently, the credit markets dried up as financial institutions – reluctant to take on any more mortgage-backed securities – became leery of lending to one another.

The carnage is already well documented, highlighted by the fall of the venerable Wall Street giant The Bear Stearns Cos. Inc. (BSC). Banks already have been forced to write off billions in losses. Now they’re scrambling to bulk up their cash reserves to protect against credit card-related losses.

As of December, Americans had $944 billion in total revolving debt, most of it on credit cards, an annualized increase of 2.7% on a seasonally adjusted basis, The Wall Street Journal reported. That rate was 13.7% in November and 11.1% in October.

The bottom line: Americans have dramatically curtailed their credit card spending.

Now you could blame the consumers’ reluctance to pull out the plastic on the slowdown of the U.S. economy, and you’d be right. But just partly. The other, more ominous reason is the likelihood that many consumers are simply maxed-out on credit.

In December, an average of 7.6% of credit-card loans were either at least 60 days delinquent or had gone into default altogether, according to research by the RiskMetrics Group.

The slowdown in consumer credit could well run through the rest of the year. But let’s not go and sound the alarm bells just yet. Although the lower numbers will have some effect on the bottom lines of both regional banks and Wall Street behemoths, like Citigroup and Bank of America Corp. (BAC), shares have already been pummeled and investor sentiment has likely bottomed out.

What’s more, a key difference exists between mortgage debt and credit card debt that will, in effect, cap the amount of damage credit card defaults can do.

Subprime All Over Again? Not Likely

According to the Fed, credit-card delinquency rates are now up by more than a full percentage point since bottoming out in the fourth quarter of 2005, marking the abrupt slowdown in consumers’ credit-card spending habits.

But the silver lining is that credit card debt is not securitized – pooled – and then sold off by banks as investment securities on any kind of scale that rivals mortgages. And that fact undermines any notion that banks may have subprime-like write-downs in their futures.

Remember, it wasn’t just the loose lending of mortgages by banks that got us into the subprime mess. It was every bit as much the over-speculation on mortgage-related investment securities, too. The latter can’t happen with credit card debt.

In a note to clients, CIBC World Markets Inc. (CM) Economist Meny Grauman wrote that “the good news in all of this is that both corporate and consumer loans are typically not securitized to anywhere near the degree that mortgages are. This means that even though losses on these assets still have the potential to weigh on financial sector earnings, they will not create the same broad systematic risks created by recent troubles in the asset-backed securities market.”

What’s more, a recent report published by the Federal Deposit Insurance Corp. (FDIC) said that 99% of insured institutions were currently well-capitalized at the end of 2007 and close to 90% of those were also profitable, despite the fact that profits at banks ­- thanks to the subprime meltdown – fell to 16-year lows in the fourth quarter last year.

Taking it to the Banks

The recent data from the FDIC clearly demonstrates how well capitalized U.S. banks are and indicates these financial institutions should be able to ride out any approaching storm. Accordingly, we’re reiterating our bullish view on the financial sector.

In an interview with MarketWatch, Andrew Gray, a representative for the FDIC, said that with only 76 banks on the FDIC’s “watch list,” problem banks are at historically low levels, despite the chaos of the last several months.

“Our problem bank list has 76 institutions, low by historical standards,” Gray said. “In 1990, there were close to 1,500 on the list.”

Five banks have failed in the last 12 months: Metropolitan Savings in Pittsburgh; Douglass National Bank in Kansas City, Mo., Miami Valley Bank in Lakeview, Ohio; NetBank in Alpharetta, Ga.; and Hume Bank in Hume, Mo. That’s a low number when you consider that over 800 banks failed during the savings-and-loan (S&L) crisis that occurred between 1990 and 1992.

“The industry as a whole is coming off a golden period of record profits,” FDIC Chairwoman Sheila C. Bair said in the agency’s Quarterly Banking Profile. “Because of this financial strength, the overwhelming majority of banks and thrifts remain well-capitalized and profitable.”

Consequently, many of the big banks are great plays at the current valuations. But rather than locking in on one target, it makes more sense – considering the prevailing market jitters – to buy shares of the Financial Select Sector SPDR (XLF). In this one ETF, you get exposure to the entire financial sector, which protects your investment against the potential for any blow-ups at individual financial institutions.

But if you insist on trying to “catch lightning in a bottle” with a single pick from the group, Goldman Sachs Group Inc. (GS) is a stellar option. Goldman is well run, well capitalized and is very liquid. The company’s return on equity (ROE) in the fourth quarter remained a stout 40%. And in a recent report to analysts, the firm said that its pool of liquidity was $80 billion, compared with an average of $60 billion during the fourth quarter. And one cannot underestimate the value of cash when investing during such an unnerving time.

After all, as the old Wall Street adage holds: “Cash is king.”

[Editor’s Note: Robert Williams, a veteran commodities trader, is the Editorial Director for The Oxford Club, and is a regular contributor to Money Morning. He last wrote about alternative energy investments. For information on an Oxford membership, please click here.]