The Lowdown on Libor

The Lowdown on Libor
Matthew Hollister

Financial institutions the world over use Libor—short for the London interbank offered rate—to set the interest paid on everything from mortgage loans to complex financial instruments. But now questions are being raised about whether the rate has been manipulated. Here's what you need to know about how Libor affects you.

What exactly is Libor?

Libor is a global interest rate benchmark that's used to set rates on $150 trillion worth of financial products. Each day, the London-based British Bankers' Assn. (BBA) surveys 16 banks, asking each for the rate they'd charge their peers to borrow cash—ranging from an overnight loan to one that matures in 12 months. From the reported rates on 15 different maturities, BBA drops the top and bottom four and averages the middle eight to calculate the rate. On May 27, the six-month Libor was 2.84938%.

What does Libor have to do with me?

Libor is a popular tool for setting rates on consumer loans. It has the biggest reach in the mortgage arena, where, for example, it was used in 2005 and 2006 to set rates on approximately 75% of subprime, adjustable-rate mortgages (ARMs)—about $700 billion worth of the loans, according to Guy Cecala, publisher of Inside Mortgage Finance. Of prime, adjustable-rate mortgages, up to 40% were pegged to Libor, too. Currently, about half of private student loans are pegged to Libor. (The rate has no effect on federal student loans, such as the Stafford Loan, which are set using fixed-rate instruments.)

What's the recent controversy about?

With the aftereffects of the credit crunch lingering, a high Libor, especially relative to U.S. Treasuries, would set off alarm bells that capital-starved financial institutions are still at risk for further meltdowns, says market research firm Global Insight's Brian Bethune. Some industry insiders have accused the banks of quoting falsely low rates for the surveys in order to force down Libor and paint a rosier picture of the lending environment. It's more likely that the banks are simply reporting their best rates, not the rate at which they're most commonly lending, Bethune says. The BBA is conducting what it calls "a regular review," with results due May 30. In the meantime, proposals have been offered to ensure Libor's accuracy, from surveying more banks to ditching Libor in favor of an alternative rate.

Do I need to worry if my loan is pegged to Libor?

Probably not. Because Libor may be lower than it should be, consumers are actually spending less on interest payments than they should be. "It's one of those rare instances where financial institutions might not be quite on the up and up, but it's worked out to the consumer's benefit," says Keith Gumbinger of mortgage researcher HSH Associates. If the BBA discovers that rates were manipulated, loan rates could bounce up the next time they are reset. Gumbinger says that would likely be the case anyway, as the Federal Reserve looks ready to stop cutting rates and perhaps even raise them as it targets inflation, causing rates on ARMs to bounce up. "If you're in an ARM—Libor or otherwise—you might want to think about getting out," he says.

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