The credit crunch is — in deed —  getting worse:

• LIBOR jumped again,
• TED spread is at a new record.
• Bad news on employment: payrolls down 159,000, average work week down, official unemployment rate flat at 6.1 percent but broad measure (U6) up from 10.7 to 11.

To understand the full impact of the credit crisis, read this article by Mark Davis of the Kansas City Star: things are deteriorating in the credit market, on Main Street, and fast …

Shock waves rippling through the financial system this week reached a seismically staggering figure: 6.875.

Experts gawked at that reading, taken early Tuesday (10.7.08), inside London’s financial epicenter after Congress rejected the $700 billion financial system bailout.

Regular folks will be feeling the aftershocks soon.

Welcome to the wild world of the London Interbank Offered Rate, called LIBOR for short.

Most people have never heard of LIBOR, and understandably so. But it lies at the very heart of the credit crisis gripping the world economy.

LIBOR is an interest rate announced daily by the British Bankers Association. Most simply, it reflects the cost of loans that giant banks extend to each other overnight.

It also serves as a benchmark used globally in corporate lending to calculate all sorts of interest rates paid by borrowers — notably, about half of the adjustable-rate mortgages in the United States.

In recent days, LIBOR has emerged from financial obscurity. What once had been a polite daily posting has become the most closely watched indicator of the credit crisis, a financial equivalent of the Richter scale that gauges earthquakes.

This week started with a mild LIBOR setting at just under 2.569 percent, a modest premium to the 2 percent target rate on short-term loans set by the Federal Reserve.

Then Congress voted down the $700 billion financial system bailout bill.

While most of the attention focused on a knee-wobbling decline in the U.S. stock market, which lost more than $1.2 trillion on the day, LIBOR reacted even more violently.

It shot up the following morning, almost tripling to that staggering 6.875 percent record rate on Tuesday. It was LIBOR’s second spike above 6 percent inside of a month.

Its spasms have corporate borrowers in America wringing their hands. It weighs heavily on Congress’s debate over the bailout bill.

And some area homeowners with adjustable-rate mortgages tied to LIBOR will feel its pinch in the future. Such loans typically look back 45 days to pick up LIBOR when they set a new mortgage rate. And since Sept. 16, LIBOR numbers used in mortgages have jumped by a full percentage point.

“If today happens to be your magic day, it’s going to reprice” higher than it would have, said Kent Townsend of Capitol Federal Financial.

Understanding LIBOR’s gyrations is no easy task.

Traditionally, it has tracked just slightly higher than the Fed’s federal funds rate.

Since the start of the credit crisis, though, LIBOR has taken on a life of its own. Now, it’s gaining new focus outside of banking circles.

“There’s so much uncertainty and volatility in the market, it’s reflecting a lot of different things and it’s hard to figure out what’s directly influencing what,” said Sam Khater, senior economist at First American CoreLogic in Washington D.C.

At its root, however, the recent spikes in LIBOR are a direct indication of the raw fear banks have of lending money even to each other, even just until the next day. None wants to be caught short because of the surprise failure of another.

Banks also are hoarding cash because of their own capital shortages, but it’s the fear factor that matters most.

The British Bankers Association determines LIBOR each day in much the same way that Olympic officials calculate diving scores during the summer games. The association asks 16 banks what they charge each other on such loans. The list includes Citibank, JPMorgan Chase, Bank of America and others less familiar to American ears.

The BBA then tosses out the four highest rates and the four lowest, hoping to strip away outliers as with Olympic diving scores. It then averages the remaining eight rates to produce the official daily LIBOR.

There are lots of LIBORs, actually. In addition to the overnight rate, there is a 3-month LIBOR, a 6-month LIBOR and others out to a 12-month LIBOR. The official rates also come in a variety of flavors, such as Japanese yen, Danish kroner and eight other currencies.

And the world runs on these rates.

The BBA says its many LIBOR settings are used to settle payments on financial products worth roughly $350 trillion. The “trillion” is not a typo.

Many corporate borrowers pay an interest rate tied directly to LIBOR. Their bank lenders charge LIBOR plus a few added points for profit.

That’s because the banks routinely turn to the London Interbank market to raise the money they lend to the corporate borrowers. It is a cheap source of dollar funding, usually.

Mark Hargrave, a partner at Stinson Morrison Hecker LLP in Kansas City, said banks also tie smaller loans to LIBOR by pooling such loans under a large borrowing of their own in London.

Business borrowers can escape an untimely spike in LIBOR if their loan agreement allows them also to switch from LIBOR to the bank’s prime rate when the loan’s interest rate resets periodically.

Many homeowners with adjustable-rate mortgages borrow at LIBOR, too, typically the 6-month or 12-month LIBOR.

According to First American CoreLogic, nearly all subprime adjustable-rate mortgages used LIBOR. Nearly half the adjustable-rate mortgages taken out by more creditworthy borrowers also track LIBOR.

The alternative typically is an interest rate tied to U.S. Treasury rates.

Homeowners with loans tied to Treasury rates will be pleased when their mortgages adjust to current rates. The financial panic has sent investors into a bidding frenzy for Treasury securities, driving those rates down.

But with LIBOR, even the 6-month and 12-month rates have jumped.

If that continues, mortgage payments will rise with them.

LIBOR questions and answers:

Q: How is the rate set?

A: The LIBOR rate is calculated every business day in 10 currencies and 15 terms, ranging from overnight to one year.

Q: How big is its influence?

A: Rates on about $10 trillion in corporate loans, mortgages, home equity lines of credit and student loans worldwide are pegged to LIBOR, usually with a markup of several percentage points. The total amount of financial contracts tied to LIBOR, particularly interest-rate swaps, exceeds $300 trillion, or $45,000 for every person in the world.

Q: How does it affect my life?

A: More than half of U.S. adjustable-rate home loans are tied to LIBOR, so a recent increase in this rate means monthly mortgage payments will rise for affected homeowners if the rise is sustained. A typical adjustable-rate home loan will adjust based on the six-month LIBOR, plus 2 to 3 percentage points.

Q: How does it affect the economy?

A: Because LIBOR has pushed up rates on adjustable mortgages as well as rates on many commercial loans, that has blunted the effectiveness of the recent interest-rate cuts by the Federal Reserve. It also means consumers can find their access to credit restricted.

No Tags

Posted in TED Spread, LIBOR | One Comment