LIBOR: The Big Fix
On July 13, 2012, in Breaking News, Economics, by Brian Summerfield
Perhaps youâ€™ve just noticed the headlines emerging around Libor, or maybe you havenâ€™t even seen them yet. Either way, this story, which has been in the European press for a few weeks now and is just now starting to get picked up on our side of the Atlantic, has big implications for real estate and mortgage finance. Hereâ€™s a quick rundown of what it is and how it could affect you.
Q: OK, letâ€™s start with the basics. Whatâ€™s Libor?
A: Libor is an acronym that stands for the London interbank offered rate (not the Long Island Board of REALTORSÂ®, at least not in this case). Thatâ€™s the average interest rate banks around the world use to lend money to each other. The rate is set (as the name indicates) in London by financial data services firm Thomson Reuters and overseen by the British Bankers Association (BBA). Itâ€™s theoretically calculated by major member banks independently submitting to the BBA their best estimates of the interest rates other banks would charge them to borrow money. When you remove the top four and bottom four estimates, then average out the remaining ones, you get Libor.
Q: Why is Libor a big deal? Iâ€™ve never heard of it until recently.
A: Libor impacts the rates used for credit card, mortgage, and student loan debt. Thereâ€™s no precise figure, but at least $300 trillion â€” and quite possibly more than double that amount â€” worth of financial products are affected by it. To put it another way, thatâ€™s more than four times the economic output of the entire world over a four-year period. So, even a tiny rate change can mean millions or even billions of dollars gained or lost.Â This infographicÂ provides a good breakdown how Libor impacts the financial ecosystem.
Q: Why is this in the news now?
A: About two weeks ago, London-headquartered Barclays bank paid nearly half a billion dollars to resolve investigations conducted by U.S. and U.K. financial regulators into the companyâ€™s manipulation of the LiborÂ andÂ the Euro interbank offered rate. While not technically an admission of guilt, the settlement shows that Barclays was culpable for improperly influencing the rate.
Q: Oh. But thatâ€™s just a rare case of misconduct, right?
A: Itâ€™s not quite clear how often it happens. However, several banks are currently being investigated by the same organizations that were looking into Barclaysâ€™ manipulation of Libor, and similar deals are expected to be reached in the coming weeks. Itâ€™s safe to say this isnâ€™t an isolated case, and educated insiders say the banks were actually communicating rates to each other before submitting their estimates to the BBA. Thatâ€™s illegal collusion.
Q: That all sounds bad. But how will that impact real estate?
A: Well, the Libor influences rates for many home loans, particularly adjustable-rate mortgages (ARMs). If the banks manipulate Libor upward, that means people with ARMs will pay more. Of course, theyâ€™ll pay less if the banks push it downward, which is good for their mortgage payment, but bad if theyâ€™re a saver or investor. Either way, their payments are being determined not by the natural, market-determined rate but rather by the banksâ€™ whims.
Even more problematic is the potential financial fallout from all this. Lenders are already skittish due to theÂ uncertain regulatory environment. A far-reaching scandal that exposes more systemic problems in the global finance system could contract credit even more. That couldÂ threaten the real estate turnaroundÂ thatâ€™s already vulnerable thanks to a sluggish improvement in employment conditions.
Weâ€™ll be following this story closely over the next few weeks. It could have big implications for your business.