What’s Libor got to do with it? Learn the origins of the Libor and how it affects California real estate agents and brokers as well as the greater U.S. economy.
What in the world is Libor?
Before the Libor scandal rocked London and Wall Street, sending the global business media into a frenzy, few people had any idea what Libor was, let alone how it affected them in their business dealings and in their daily life. Before we get into any scathing critique of the benchmark rate and its manipulation by Wall Street, let us first explain exactly what Libor is.
The London Inter-bank Offered Rate, known as Libor, is a benchmark interest rate set by the British Banker’s Association (BBA) to estimate the cost of borrowing between banks, which is an essential practice for banks to maintain liquidity and lend funds to consumers. Banks needing money borrow it from other banks that have excess cash and then lend it to consumers, paying one another back and profiting on the additional margin charged to the consumer. Although the Libor is used as a benchmark for setting a vast variety of rates, this is its fundamental purpose.
In all of the discussion of Libor in the media of late, few have explained the progenitors of the mysterious rate, the BBA. The BBA is a trade union for British bankers. It is essentially a collective of nearly every bank and financial services company in the UK that “protects the interests” of the banking organizations.
Their role in the Libor is essential. In fact, Libor is often referred to as the BBA Libor since it is the members who belong to the BBA that collectively determine the rate.
The USD Libor
Since Libor is used as an international benchmark for pricing a myriad of financial products and services, a separate calculation is made for each currency. The U.S. dollar-denominated Libor is the most widely used, if for no other reason than that the U.S. dollar is the dominant currency in global financial dealings.
For the U.S. Libor, the big banks, including Citigroup, JPMorgan Chase, BofA and, uh hum, Barclays, estimate how much they will charge one another on the following day for interbank loans. They then submit these best guesses, based on current market volatility, to Thomson Reuters, an “independent third party,” who calculates the average and publishes the rate daily.
Since it is an estimate, based on the previous day’s market behavior, the actual rate at which banks charge one another for short term loans varies, thus the Libor acts as a guide but not a rule for interbank loans. As a benchmark, however, the Libor is followed to the decimal.
Libor is referred to as a benchmark since it is used as a starting point to price other financial products and services. A common phrase bandied about in the world of finance is Libor plus x percent.
The rate is considered an excellent benchmark since it is updated daily. The philosophy of the self-regulating market underpins the Libor’s accepted reliability. It is believed that since the banks rely on one another for the liquidity crucial to their business, no one bank would cook their estimates since their profitability depends on the accuracy of the rate on any given day.
The second failsafe involved is the so-called law of averages. Since the Libor is an average of many banks’ estimates, any gross discrepancies from one estimate to the other will be worked out in the average. Of course, we know now that both of these ideals are untenable at best and pure folly at worst.
To answer this question we need look no further than Wall Street.
Of all the financial products linked to the Libor, it is the adjustable rate mortgage (ARM) that primarily concerns us here in the real estate market. The Libor was not always the gold standard benchmark for setting ARM interest rates. In fact, it was not adopted by some lenders for indexing ARMs until the 1990s.
Before Libor’s entrée into the ARMs scene, the 11th District Cost-of-Funds Index was the preferred benchmark. The cost-of-funds index was compiled every month, as opposed to the daily Libor rate, and was based on the average cost-of-funds for mortgage lenders over a 30-day period. Thus, the cost-of-funds index was much less volatile and far more accurate than Libor for pricing home loans based on lender costs for obtaining funds.
Once the mortgage-backed bond (MBB) market began picking up steam in the 1990s, Wall Street investment banks began groaning that the cost-of-funds index was preventing them from properly hedging their investments since the benchmark was only applicable to mortgage rates and didn’t include any other form of securities. Further, the MBB market in the U.S. was gaining international favor and global investors were looking for a universal standard for placing and hedging their bets. Libor was Wall Street’s answer to all of these problems.
In effect, the banks were given carte blanche for pricing these products, all based on their, well, word. Along with the credit rating agencies, who we now know were slapping AAA ratings on subprime junk heaps called “investments”, Wall Street and Libor were a match made in rentier heaven.
The big deal
Many in the real estate and mortgage industry are asking, what is the big deal? If Barclays and the BBA members colluded to keep the rate artificially low, homeowners placed in Libor-indexed ARMs actually saved money, right?
Let’s put this one to bed right away. The only institutions that made money off of cooking the Libor books were the big banks. Here’s why. . .
It is true that the Libor debacle uncovered at Barclays has to do with keeping rates on ARMs (and all other Libor-indexed products) artificially low. This occurred leading up to and during the 2008 financial crisis when markets participants were responding to the finance fiasco by raising rates through the roof to reflect the then astounding amount of risk in the market. Yet, Libor remained unchanged, a deliberate deception supposedly to quell fears of a pending massive money meltdown and soothe the markets.
Here’s the rub — rates on ARMs were held down not just to keep investors confident, but also to remain enticing to borrowers, which includes homebuyers. Even when it was abundantly clear the real estate market was inflating into an unprecedented bubble, the lure of easily attainable financing at ungodly low ARM rates kept the buyers coming in. This kept the securities bond market machine cranking, which continued to feed hungry investors lulled into credulity by the golden benchmark.
And what happened to those buyers who all got a sterling “deal” due to the rate manipulation? Many fail to mention that the deal was had at the cost of grotesquely inflated real estate prices and hybrid adjustable payments big enough to float the Titanic over the iceberg. Thus, job loss, default, foreclosure, bankruptcy; the rest is history.
This is the “deal” that Wall Street would like borrowers to think they were getting. In true Wall Street sleight-of-hand, the rate on the paperwork was kept low to keep the numbers behind the scenes (originations) as high as possible.
So what’s the moral to this story? When placing an average end user in an ARM, think twice about your fiduciary duties to your client. If ARMs are indexed to Libor and fixed rate mortgages are indexed to U.S. treasury bonds, which one is safer? Which one would you use?
The bottom line is, all ARMs are a leap-of-faith gamble, meant for financial speculation in the real estate market and comparable to placing bets on stock movement. They are not for owner-occupant homebuyers looking to finance the government-supported American dream.