Contrarian Stock Market Investing News - Featuring Bargain Stocks » London Interbank Offer Rate

How Will We Know the Credit Crisis and Banking Fiasco Are Truly Over?

Keith Fitz-Gerald — Thu, 12 Jun 2008 18:29:32 +0000

How will we know the credit crisis and banking fiasco are truly over? We won’t.

But there’s a damn good indicator that will show us the way – the London Interbank Offer Rate, usually referred to as LIBOR.

And right now LIBOR tells us that this financial mess still has room to run.

As indicators go, recent developments have demonstrated that the LIBOR system is arguably corrupt. Until now, LIBOR always has been constructed by industry insiders – with little in the way of oversight or regulation. It drives billions of dollars of trades and transactions a day. And it’s publicly available at 11:30 a.m. (London time) each business day.

Now regulatory authorities are investigating the entire LIBOR process, and that makes it as close to insider information as we’re going to get.

LIBOR is calculated entirely using data provided by insiders from 16 banks and reflects the daily borrowing rate in U.S. dollars, European euros and Japanese yen that banks extend to their best customers – each other.

Theoretically, it’s a measure of what the banks must charge for money and that’s how the rest of the world uses the LIBOR rate.

But as we’ve hinted, there’s a far darker side and, as usual, we’ll tell you about it even though other insiders won’t.

Interest rates are not really a cost of borrowing – even though that’s how they are portrayed to the public. To insiders, interest rates are a measure of risk. So even though banks and financial institutions use the daily LIBOR rate to “price” billions of dollars worth of financial instruments, what these institutions are really doing when they post their LIBOR rates is to look at each other’s credit quality and assign a risk premium.

Thus, if LIBOR rates are rising, one way to interpret that fact is to conclude that the risk of doing business with other financial institutions is going up to. That creates an incentive for banks to “fib” when they submit information on the rates at which deposits were being offered.

That’s because – as my colleague Martin Hutchinson noted way back on April 18 – “any whisper of trouble over a bank makes other banks’ dealers not want to place money with them.”

This is true even when the financial markets are healthy and in good shape. But it’s even truer when – as now – the markets are rattled and facing severe inflationary pressures.

Here’s why: The higher the LIBOR rate goes, the greater the risk of perceived default and the poorer the credit quality associated with the 16 banking heavyweights that submit the rates used to calculate LIBOR. What’s more, those negative perceptions work their way through the balance of the world’s financial system as a giant cascade of interlinked financial instruments.

If this doesn’t make sense, think of it this way: What happens with LIBOR is not any different from what happens with rates assigned to home mortgages and credit cards – just on a far larger scale. If you’re a good credit risk, you get low rates. If you’re a bad credit risk, or are a high-risk borrower, you must pay higher interest rates because banks and other potential creditors view you as more likely to default on your obligations.

The bottom line is that LIBOR can actually be viewed as a kind of leading indicator.

In fact, I suggested as much back on May 8, when I correctly warned readers that the dollar rally under way at the time was nothing more than a “head fake of legendary proportions.” At that point, the consensus view was that the dollar was finally emerging from a decline that had taken it down to record lows against key world currencies.

But when I noted that LIBOR was rising in concert with the dollar’s embryonic rebound, it was clear to me that something was rotten in Denmark – or, in this case, London. Given that realization, I was able to conclude that the dollar’s strength was nothing more than a temporary aberration and that the greenback would resume its decline once the inevitable new round of problems emanated from the financial-services sector.

And that’s exactly what happened.

Since Money Morning published my “head fake” prediction, the “dollar rally” sputtered and died and the greenback resumed its downward spiral. And the catalyst for that dour turnabout was just what I’d predicted – a whole new round of financial write-downs and headlines about banks and investment banks facing major problems. Indeed, just this week there’s been bad news surrounding Lehman Brothers Holdings Inc. (LEH), which wrote down another $3.7 billion in mortgage-backed assets.

So what’s LIBOR telling us now?

That’s simple. First, it’s telling us that this mess is far from over. And second (and potentially even worse), it’s making it very clear that inflationary worries are escalating.

It’s also clear to me that the distrust between banks is growing. The three-month LIBOR rate recently jumped 10 basis points to reach 2.79%, representing the biggest LIBOR increase since August and the highest LIBOR level since April 30.

Which is why it would seem that there are more financial shenanigans to come. Indeed, I feel a bit like the announcer on the old Batman TV series, asking in my best, scene-setting baritone voice:

“Could it be that we’ll see another round of financial house cleaning in the next 90 days? Or are there additional credit-induced write-downs and earnings disappointments headed our way? To find out… tune in next week at the same Bat Time, and the same Bat Channel…”

LIBOR seems to be telling us that there’s enough drama for several more episodes.

[Editor’s note: Since this article was prepared, word has escaped from London that the biggest banks in England may be preparing to swap nearly £90 billion pounds sterling worth of mortgage-backed assets for U.S Treasury Bills with the Bank England. And, judging from how globally linked banks are these days, where there’s smoke, odds are good that there’s fire, too. That means we could see everything from higher interest rates globally to increasing defaults and heightened personal consumer financial trauma. Although that will create fear in the market place, it’s important to note that with fear, comes opportunity.]

Source: How Will We Know the Credit Crisis and Banking Fiasco Are Truly Over?

‘Libor’ Sends Another Shaky Signal to the Global Financial Markets

Martin Hutchinson — Fri, 18 Apr 2008 18:14:28 +0000

The news that the London Interbank Offer Rate (LIBOR) system of setting interest rates is running into trouble was surprising at first glance.

It seems some banks are giving phony LIBOR quotations that don’t reflect the true rates at which they accept deposits. In the perfect financial system, beloved of regulators and academics, this kind of discrepancy shouldn’t happen.

In the real world it does, and I’ll explain why.

The LIBOR system was set up in the 1960s, when the market for dollar-denominated bank deposits outside the United States grew big enough to worry about. On a daily basis, the British Bankers Association would go to 16 banks, which were thought to be top quality, and ask those banks at what rate deposits were being offered. Assuming an honest reply, the data would be compiled to determine the average rates at which deposits were offered to prime banks. The average of the 16 banks becomes that day’s LIBOR – for 1-month, 3-month, 6-month or other period deposits.

Should be a foolproof system, right?

Not quite. To see what can go wrong, let me share a little personal story. Ten years ago, when I was working in Zagreb, Croatia, I advised on the establishment of a LIBOR-type market between Croatian banks for 1- and 3-month deposits in Croatian kuna. We called it the “ZIBOR” market. Realizing that very few Croatian banks were solid credit risks at that time, I suggested that the bankers’ association restrict the system to no more than the three top banks.

Naturally, since I was only the advisor, they ignored me and let in all the large members of the association – seven in all.

The system worked fine for a time, but then a credit crisis struck. NATO got upset about Kosovo and started bombing the neighborhood. Only occasionally did bombs accidentally fall on Croatia, but the bombing played merry hell with Croatia’s tourist business. The result was a liquidity crisis in Croatia, and big trouble in the ZIBOR market.

I heard some grumblings that ZIBOR had become unrealistic and been investigated. There were two problems:

First, one of the ZIBOR banks, Splitska Banka, was in such horrendous shape that no other bank would offer it deposits at all – not at any rate. Splitska was naturally interested in continuing to participate in the immense honor of the daily ZIBOR fixing, so its dealers would insist on going last. They would ask what the other banks had quoted, and then quote the average. Perfectly sensible solution, as I told everybody, provided none of the other banks took to doing it – it just meant there were only 6 banks really quoting ZIBOR, but six was still plenty.

The second problem occurred as liquidity got worse, and consisted of banks complaining that they were actually being asked to place deposits. Other banks would ring them up and ask them to place deposits at ZIBOR. They complained that this was impossible, since most days, they hadn’t any money. Admittedly, the ZIBOR “reference amount” (the amount for which the quotation was supposed to be good) was only 100,000 kuna, or about $15,000. But some days even that amount was difficult to find. They wanted to reduce the reference amount to 10,000 kuna ($1,500), presumably so that if they were asked to place a deposit, the bank’s chief executive officer could conceivably raise the money on his credit card!

So much for emerging-markets banking. When I returned to the United States in 2000, I thought I had left all that behind me. Apparently not!

Banks are now apparently making fake LIBOR quotes on the grounds that they don’t want to be thought of as a credit risk, from which other banks would then demand a premium. Just like the old days in Zagreb!

But given the subprime mess, some large banks are rather dodgy credit risks, and they should be paying a modest premium for their deposits. In the 1974 credit crunch, some perfectly respectable Japanese banks paid a premium of as much as 2% for their short-term dollar deposits.

In these volatile markets, any whisper of trouble over a bank makes other banks’ dealers not want to place money with them. Their feeling is that there’s no point in getting fired for doing business with another bank that goes bust, especially as you’d probably be losing your job at the bottom of a bear market, when times are tough. So it’s not surprising that the LIBOR system is wobbling a bit.

Despite its troubled history, Croatia’s ZIBOR has survived to this day. And it’s likely that LIBOR will do the same. However, there needs to be some realistic threat of banks being banned from participating in the LIBOR system if they provide false quotes. There also needs to be some realization that, in a tight market, not all banks will borrow at the same rate.

The real problem is the hundreds of trillions of dollars of derivatives contracts that use LIBOR – $382.3 trillion in interest rate swaps alone at the end of 2007, according to the International Swaps and Derivatives Association Inc. Just a 0.10% error on a six-month deposit, quoting 2.75% when the rate is really 2.85%, may not sound like much, but if it’s repeated over $382.3 trillion in LIBOR quotes for interest-rate-swap contracts it comes to a fair piece of change. A lot of change. To be precise, we’re talking about $194.3 billion.

Now that’s what I call an accounting error.

It looks to me like it’s a major problem. But it’s one the world will just have to live with.

And there seem to be a lot of those kinds of problems, right now.