How LIBOR Threatened to Destroy the Global Banking System

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By Martin Hutchinson
Contributing Editor
Money Morning

The largest financial crisis since the Great Depression has revolved around an interest rate that many U.S. investors are only now hearing about for the very first time: The London Interbank Offered Rate (LIBOR).

But if you understand that rate, and study the forces that have been influencing it, chances are very good that you can figure out how we can escape the current banking-sector mess without wrecking the entire world economy.

Although not a common term here in the U.S. market (where it nevertheless is a presence, as we’ll see), it is common knowledge in Europe, and especially in Great Britain, where LIBOR rates are published daily by the British Bankers' Association (BBA).

The London interbank market grew up in the late 1950s as a market for dollars held in Europe. It was separate from the U.S. money market, if only because it took place in different time zones. The rate at which dollar deposits were offered between top-quality banks based in London (both domestic British banks and the London branches of worldwide banks with their headquarters elsewhere) became standardized as the London Interbank Offered Rate.

When money is readily available and the system is working smoothly, LIBOR is uncontroversial: Except for in a few extreme cases, all banks participating in the London market pay close to the same LIBOR rate, because they are all assumed to be solid credits for short-term interbank deposits.

The first time in which the LIBOR system came under stress was in the credit crunch of 1974. The collapse of Bankhaus I.D. Herstatt in June of that year and Franklin National Bank in October frightened the London banks, and made them worry that other banks could unexpectedly disappear, endangering the Interbank-deposit system.

After that happened, the London banks began to insist on higher rates from banks that were thought to be in danger. At the peak of the illiquidity in late 1974, the Japanese trust banks – actually of fine credit quality but at a disadvantage in that they’d only recently set up shop in the London market – were paying as much as 2% more for their deposits than were their U.S. and British competitors.

That brings me back to the current LIBOR debacle. Late last year, when it became clear that the LIBOR market was seizing up, I wasn’t surprised, given all the credit problems in the banking system.  After all, if the market perceived banks as suddenly riskier, you would expect the differential between three-month LIBOR and three-month Treasury bills to widen, as lenders demand higher rates from the newly riskier banks.

However, you would also expect the rate differential between banks to widen as it did in 1974 – you would expect LIBOR for the top quality banks to be well below the rate for the competitors.

Of course, that’s not what has happened. Three-month LIBOR is roughly 4% more than the yield on three-month T-bills. But there’s much less differentiation between LIBOR for different banks – in general, we’re talking about only a quarter percentage point from top to bottom.

What’s more, when the U.S. Federal Reserve auctioned $150 billion of three-month money last week at 1.4% – far below LIBOR – it wasn’t taken up. If credit risk were the problem, that would make no sense: You could pick up more than 3% per annum by borrowing from the Fed and lending to a bank you trusted.

Clearly, credit risk isn’t the problem. Banks aren’t worried about a possible default of JPMorgan Chase & Co. (JPM); they just don’t want to make interbank deposits at all, because they are trying to reduce leverage.

Banks borrowed too much money in relation to their capital during the bubble years, so their leverage (roughly their total assets to tangible stockholders’ capital) got too high.

That high leverage makes a bank more profitable in good times, but it increases a bank’s risk in a downturn, because each dollar of capital has to support the losses on $15, $20 or even $30 of assets. Since last fall, banks have suffered losses on holdings of low-quality debt, which has reduced their capital. At the same time, they have been forced to take back onto their balance sheets assets that they had thought were safely parked in “Structured Investment Vehicles,” or SIVs, that were funded with commercial paper – and now the asset-backed commercial paper market has cratered.

Now, banks’ best corporate customers are coming to them for commercial loans, because the commercial paper market in general has run into trouble – more assets banks really don’t want.

With their assets being forced up and their capital down, banks must reduce their leverage fast, either by reducing assets or by increasing capital – or, ideally, both. Otherwise, the market will view banks as being too risky – a distortion that will boost their borrowing costs and decimate their profits.

One way to reduce leverage is to avoid participation in the interbank market, which is a low-margin business that increases assets without doing much for income. At the same time, even cheap short-term liabilities aren’t that attractive; long-term debt (to improve their liquidity position) and proper capital is what banks need.

As I’ve noted before, the $700 billion Troubled Assets Relief Program (TARP) passed by Congress addressed the wrong problem. By buying $700 billion of banks’ lowest-quality assets, the TARP would reduce those institution’s assets by only the same $700 billion. It might even damage their capital position, if the banks were forced to write down the assets further and to then sell them to the TARP at a loss. In that form, the program would do very little for banks’ No. 1 problem: Their leverage.

Under a revision engineered by U.S. Treasury Secretary Henry M. “Hank” Paulson Jr., TARP was re-cast to involve direct capital injections into banks. If the bank’s desired leverage is 12 to 1, then $10 billion of new capital allows it to support an additional $120 billion of assets, reducing its leverage problem far more than would $10 billion of asset sales. With Britain and other countries making similar capital injections, the LIBOR market has this week greatly improved. The interbank market liquidity problem has not gone away altogether, but has been rendered much less serious.

Over the next few months, there is likely to be more differentiation in the market. At one end of the continuum will sit a majority of good banks, for which the government’s capital has removed all danger, meaning these institutions will try to expand their lending business in a market where lending is much more profitable. Their new profits may not help shareholders much initially, as losses still will be caused by old problems being written off. But in the long run, these banks will provide very attractive returns for shareholders – paying off their government capital once market conditions have eased fully.

At the other end of the continuum will sit a small group of banks that face a very disheartening reality: The old problems on their balance sheets are larger than the total amount of the new capital they have received and the money they can earn from new lending. As the market discovers these banks’ more severe problems, the LIBOR rates for different banks will diverge, as they did in 1974. The bad banks will find it more expensive to attract funding, their profitability will decline further and they will become uncompetitive on the best new lending opportunities. Eventually, they will be forced out of the market, either through bankruptcy or some other process that culls the weak players from the strong. [For a related story that details how the U.S. loan market is looking brighter for creditworthy firms -- even as it gets darker for firms perceived as being bigger risks -- check out this related story elsewhere in today's issue of Money Morning.]

For the rest of us, we can rejoice that the government’s capital injections have solved the problems of most banks, and look forward to lending conditions finally easing a bit in the months to come. That hopefully will prevent the U.S. and global economies from sliding into Great Depression II.

It also should create some very good values in stocks. But maybe we should look at industrials – that carry very little debt – as opposed to banks, at least until the market has sorted out precisely which banks will survive long-term.

[Editor’s Note: When it comes to investment banking and the international financial markets, Money Morning Contributing Editor Martin Hutchinson brings readers a unique brand of expertise. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo.  Hutchinson warned Money Morning readers about the dangers of credit-default swaps back in April – long before the collapse of American International Group Inc. (AIG) made the a household word – and his recent analysis of how the U.S. stock market would respond to the credit crisis proved to be incredibly accurate. Hutchinson is also a regular contributor to our monthly investment newsletter, The Money Map Report. And right now, new Money Map subscribers can receive a free copy of the Jim Rogers best-seller, “A Bull in China” – which, ironically, details investment plays in the one market – Mainland China – we believe offers investors the best possible returns for the next few years to come.]

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  1. Mark Baumann | October 21, 2008

    This is a well written and informative article.
    From it I am developing a bank investment strategy:
    Watch for the divergence of libor rates on banks, the higher rates will be charged to the riskiest banks, likewise, the lowest will be charged to the most solid banks. Short the highs go long on the lows.
    "As the market discovers these banks’ more severe problems, the LIBOR rates for different banks will diverge, as they did in 1974"

    How do I track the LIBOR rates for different banks?

  2. Donald E Swibes | October 21, 2008

    Does "The money map Report" cost $49.0/mo or per year?

  3. admin | October 21, 2008

    That is per year. Thanks for your interest.

  4. Online Trading | October 22, 2008

    An excellent article which I shall reference from our site

  5. Andrew Smoak | October 23, 2008

    I wish they would make the banks all pay the price for their mistakes. Leverage was the key abuse, otherwise they would not be so deeply troubled. The U.S. rates will have to rise in time, as we have inflation on the horizon. Also, the unscrupulous British Banker's Association has been setting the (LIBOR) rate too high & they are completely out of touch with today's reality. The European market has seized up again, therefore they have no business being 3-4 points above the short-term U.S. Treasury Bills. I guess we all need to give up on the banking system & Fiat money.
    Maybe gold & silver will need to make a come back after all!

  6. Michael R. Scott | October 26, 2008

    Dear Sir,
    Who is kidding who? The Libor is high because many of the banks are holding, nearly worthless auction rated securities on their assets sheets at their original, inflated values. Only when those securities are listed seperately as "assets" and only when they are fairly valued, can we hope that the Libor rate will come down And then only for the few prudent lending institutions that did their research and stayed away from these toxic instruments.
    Michael R. Scott

  7. chris erickson | October 27, 2008

    Well the goverment has bailed out the banks & wall street & their stocks still fall & they wont lend money out & as I said before they have raised intrest rates ..So now what . we are lossing jobs , laying people off & the politicians are still deff dumb & blind , so are the banker / lenders… They fore close intead of lowering the intrest rate .. They people who made a fortune are being saved after they stole all the money … The Fed has lowered intrest rates to 1.5% ; yet the banks still want to charge 6 to 7 % interest…So what is the gov going to do for main street besidesraise taxes ..I said before that to fix this mess the banks , lenders ; holders of these loans/enities need to adjust the intrest rates & that the goverment now that it has taken Fanni & Freddi back can do this ; the banks that dont want to help let thim fail…The intrest rate should be dropped on all existing loans to 4.5% fix for 30 years …Instead they are letting a bank rate set in europe control the rates in this country it is call the LIBOR..This is b/s & stupid so the banks will have more forecloseures & failures then they willwant more help … as I said in previous posts use the KISS rulwe keep it simple stupid.But nobody gets ir espicialy congress aa7 the banks / holders of the so called toxic debt…..

  8. C Jooste | October 27, 2008

    This is well written, researched and informative. We use these rates (leveraged for the interest with no leverage on the investment) as part of our income in our company.

    We found that very few people outside the banking sector knows about this.

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