Libor – How rate-setting works

Those of us who deal with real estate realize some loans have interest rates that vary or change. But did you ever wonder how and why the changes take place?

In the early 2000s adjustable rate mortgages were common in residential transactions. Interest rates were fixed usually for 1, 3 or 5 years then could change based on so many percentage points above an index, which often was the going rate for certain types of U.S. Treasury securities. In the commercial world, interest rates often varied as often as daily, based on fluctuations in the price of similar U.S. Government debt instruments.

The good news in both instances is interest rates followed the market.

But as the residential and commercial lending arenas expanded, new loan products were developed to appeal to different tastes. Or, said another way, to take advantage of different appetites for risk.

Enter Libor – London Interbank Offered Rates – the rates lending institutions charge when lending to each other. Although Libor got its start in 1986, it didn’t catch on in residential transactions until a couple of decades later. But as an index for residential mortgages, use of Libor – a bank-to-bank lending product – was probably misplaced. Still, variable rate mortgages began to appear using Libor as an index because bank-to-bank lending rates tended to be low.

How does Libor work? Each day, the British Bankers’ Association publishes rates in 10 currencies for loans between banks for terms ranging from overnight to one year. The rates are set in the London time zone, so don’t account for market conditions developing later in, say, New York and Asia.

A cynic might say Libor emanates from a smoke-filled room, because it’s calculated by a daily morning survey of 20 big banks (the number used to be 16) to determine the rate each bank thinks it would have to pay to borrow money from the others. The BBA throws out the 5 highest and 5 lowest rates and averages the remaining 10 to come up with its rates.

According to the Financial Times, more than $350 trillion in financial products are based on Libor. The FT also reported recently that UBS, the Swiss bank, has been subpoenaed by U.S. regulators “…over whether it had made ‘improper attempts’ to manipulate those rates.” If, for example, during the 2008 economic meltdown, a weakened bank predicted a high rate for borrowing, would a competing bank resist lending to it, worried about a Lehman Brothers-style default? Possibly. Which might tempt the weakened bank to misstate its borrowing rate, thereby skewing the Libor rate-setting process.

There’s no question the meltdown caused sharp bank-to-bank interest rate spikes as stronger banks grew suspicious of their sister institutions, which meant Libor-based variable rates in turn elevated dramatically. As a result, monthly installments of Libor-indexed residential mortgages shot off the charts, sometimes quadrupling the initial monthly payment. Not only were borrowers shocked; many began to default.

Yet another instance of borrowers having no inkling of what they were getting into.

- Morrie Erickson