[This is the ninth installment of an ongoing series in which retired hedge-fund manager R. Shah Gilani breaks down the credit crisis for readers.]
By Shah Gilani
It's panic time for U.S. legislators, regulators, banks and lenders. More than $24 billion worth of adjustable-rate mortgages (ARMs) are expected to "re-set" to higher interest rates in November – boosting the likelihood of further home foreclosures.
And it gets worse. That increase in borrowing costs will spread to other parts of the global debt market, representing an across-the board threat to corporate, institutional and sovereign borrowers. If interest rates remain high and interbank lending remains tight, the credit crisis is not likely to recede.
This raises two key questions. Are desperate times prompting desperate measures? Is LIBOR being manipulated by banks that are trying to make their financial positions appear better than they really are?
If that's the case, it's one more reason the credit crisis will fester and spread undetected: The artificially low interbank lending rates removed a key "early warning" indicator, leading investors to believe the credit market was healthy when it actually wasn't.
The Lowdown on LIBOR
LIBOR, or the London Interbank Offered Rate, is arguably the most important interest rate in the world. It is used to calculate the interest rates on hundreds of billions of dollars of corporate debt, mortgages and innumerable other loan products – including hundreds of trillions of dollars of derivatives.
It is important to understand that LIBOR is a "reference" rate, meaning it isn't imposed on a borrower by any regulation or law. Developed in the middle 1980s, LIBOR is the benchmark rate banks use when they offer to lend unsecured money to other banks in the London wholesale money market.
LIBOR was created to make sure that banks that offer loans with "floating" – or adjustable – interest rates know just what their constantly changing cost-to-borrow actually is.
Lenders offering floating or adjustable rate loans typically charge borrowers a "spread" above LIBOR. When you hear: "Your cost on this loan is three-month LIBOR plus 5," it means the lender is charging you the three-month LIBOR rate – plus an additional five percentage points. If three-month LIBOR is 4%, your actual rate is 9% (4% + 5% = 9%). If your loan re-sets in the future, it will do so based on the LIBOR rate that day – plus an additional five percentage points.
LIBOR is calculated for 15 different loan durations, ranging from overnight to a year, and is listed in 10 different currencies. For this discussion, we are focusing on only the dollar LIBOR rate, which is the rate, in terms of dollar borrowings, that banks theoretically charge each other when buying and selling dollars in the London market.
Each morning, "panels" of banks submit loan data to Thomson Reuters PLC (ADR: TRIN) in London, usually by 11:10 a.m. London time, and Reuters (a news, information, data and market quoting service corporation) calculates LIBOR, which is subsequently published each day by the British Bankers' Association (BBA).
Subverting the System
That brings us to the current problem in the LIBOR market: As Money Morning has previously reported, there's substantial evidence that LIBOR is being "managed." This has been happening and the BBA is actively looking into it. In fact, several months ago, when the BBA announced it was speeding up its probe, LIBOR jumped.
The dollar LIBOR rate, or "fixing," as it is known, is calculated based on the submission of quotes from 16 major world banks. The banks send in data as to what they paid, or could pay, to borrow from other banks at each maturity level. Reuters throws out the four highest and four lowest quotes, and calculates the average of the eight that remain to come up with the dollar LIBOR fixing.
If banks are seeking to charge one another higher rates, that's telling us one of two things. Either:
- Banks don't have excess cash to lend.
- Or they are unwilling to lend freely to other banks, which they fear are facing potential troubles because of bad loans, defaulted mortgages, and other pending hits to their capital and threats to their solvency. [Pending hits to capital could include anticipated higher foreclosure rates brought on by mortgage re-sets].
No bank wants to admit it is being charged a premium to borrow: That sends a bad signal. If a reporting bank submits data that shows its own borrowing costs are higher than average, it will very likely raise questions about that institution's financial strength and stability – the kind of uncertainty that recently brought down such financial institutions as The Bear Stearns Cos. [now part of JP Morgan Chase & Co. (JPM)], and Lehman Brothers Holdings Inc. (LEHMQ).
So what might that bank do? Since the submitting banks providing data to Reuters are on the "honor system," maybe this institution has an incentive to not submit its actual borrowing costs? Maybe this bank submits rates at which it could borrow – which it is permitted to do, by definition, under the submitting rules – if those rates are lower by virtue of only being a quote it received?
Maybe this bank – and the rest of its brethren – would like to keep LIBOR lower than the interbank rate should actually be, realizing that if rates rise, bad-loan exposure increases. And if bad-loan exposure increases, derivative exposure will escalate, too. What if U.S. ARM re-sets (based on LIBOR) bump up the interest-rate charges that already-strapped homeowners have to pay? What will more foreclosures do to already-battered bank balance sheets?
We already know the answers to those questions.
Since the interbank-lending markets here in the United States have not been freed up, the U.S. Treasury Department and the U.S. Federal Reserve have gone to extraordinary lengths to thaw out the frozen markets and get credit flowing across the economy. Included in their buckshot-pattern arsenal of misguided turnaround initiatives is one that forces the largest U.S. banks to borrow directly from the government. That initiative hasn't helped because banks are simply afraid to lend to other banks because of the problem of toxic balance sheets and future loan-loss probabilities. Worst of all, no bank's balance sheet has become a single bit more transparent. Nor will that ever happen if we do away with fair-value, mark-to-market accounting.
But, last Friday, at the same time Citigroup Inc. (C) reported November re-sets on adjustable rate mortgages will exceed $24 billion – which can only lead to further mortgage defaults – it was also revealed that some of the banks our government gave money to actually lent it to banks in London. Strange? Not really.
When JP Morgan, Citigroup and other big U.S. banks place money with London banks, specifically banks that submit borrowing cost statistics to Reuters that ultimately determines the LIBOR fixing, could it be that there's more than free-flowing lending going on? Did the London banks lend any of the pittances that the U.S. banks lent across the pond?
By simple virtue of actually having more money to lend, and without any lending between themselves, London banks have the cover to say: "There's money available to borrow, but we didn't borrow any, but we could have borrowed and the cost to us would have been lower than it has been."
So, they submit to Reuters the lower cost at which they could have borrowed and, presto, the LIBOR fixing is lowered.
Blueprint for a Turnaround
Desperate times, it has been said, require desperate measures.
While it is imperative that credit flows freely here and around the world, the desperate and manipulative measures that banks, the Treasury Department and the Federal Reserve are employing are the equivalent of the Air Force using a carpet-bombing campaign when it's clear that a couple of smart bombs would do a better job. As a result, U.S. taxpayers are being bombed into a deeper, wider and steeper crater from which it will be very difficult – if not impossible – to climb out of.
There's just not enough dirt to fill in the craters created by the repeated pounding of the errant policy bombs, as well as the disinterested and abetting regulation, unencumbered Wall Street greed and the profligate orgy of spending that's come to define Main Street.
Fixing this massive problem – of which LIBOR is just an element – will take time. But we can start by taking all the lobbyists, ex-legislators and ex-regulators and their former staff members (and perhaps some current legislators who are serial enablers of such problems, and who enrichen themselves each time along the way) and burying them in the craters as we fill the holes in.
That rant aside, devising an actual fix for our problems starts by understanding just what it was that caused them. We can assign blame later. For now it's far more important to stop the flood of red ink that's washing down Main Street.
Understanding LIBOR and what's really going on is critical to understanding the motivation and maneuvering of the players that have us headed for a worldwide financial Armageddon.
[Editor's Note: Contributing Editor R. Shah Gilani has toiled in the trading pits in Chicago, run trading desks in New York, operated as a broker/dealer and managed everything from hedge funds to currency accounts. In his just-completed three-part investigation of the U.S. credit crisis, Gilani was able to provide insider insights that no other financial writer or commentator could hope to match. He drew upon the experiences and network of contacts that he developed through the years to provide Money Morning readers with the "real story" of the credit crisis – and to propose an alternate plan of action. It's a perspective on the near-financial meltdown that more than 140,000 readers have read in Money Morning alone – to say nothing of the hundreds of other Internet outlets worldwide that have picked up and published Gilani's unique insights.
If you missed Gilani's investigative series, Part I appeared Sept. 18, Part II ran Sept. 22 and Part III was published Sept. 24. Gilani's plan was published on Sept. 25 as an open letter to U.S. Treasury Secretary Henry M. "Hank" Paulson Jr. It actually contains contact information for readers who still wish to protest the government's action with the bailout bill by passing their disenchantment along to their elected representatives in each state's governor's mansion, and in both the House and the Senate. Check out Gilani's plan of action.
How can you protect yourself? Well, with the U.S. financial markets in such disarray, Money Morning is looking for profit opportunities beyond U.S. borders: For instance, just check out this new report on a Wisconsin-based company we've discovered that's posting quarter-after-quarter of earnings surprises – while the rest of Wall Street tanks. Not only does this company have a lock on China – the fastest-growing market on the planet – this corporate gem is also riding the profit wave of the most-powerful global trend we're following right now. If you act immediately – as an added bonus – you'll also receive a free copy of CNBC analyst Peter D. Schiff's New York Times best-seller, "Crash Proof: How to Profit from the Coming Economic Collapse."]
News and Related Story Links:
Money Morning Special Investigation of the Credit Crisis (Part I):
The Real Reason for the Global Financial Crisis…the Story No One's Talking About.
Money Morning Special Investigation of the Credit Crisis (Part II):
The Credit Crisis and the Real Story Behind the Collapse of AIG.
Money Morning Special Investigation of the U.S. Credit Crisis (Part III):
How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System.
Money Morning Special Report: How to Fix the Credit Crisis (Part IV):
Dear Hank: Here's How to End the Credit Crisis at No Cost to Taxpayers.
Money Morning Special Investigation of the U.S. Credit Crisis (Part V):
Heads They Win, Tails You Lose: Why the Bailout Plan Will Fail U.S. Taxpayers.
Money Morning Special Investigation of the U.S. Credit Crisis (Part VI):
Credit Crisis Update: An Inside Look at the Commercial Paper Debacle.
Money Morning Special Investigation of the U.S. Credit Crisis (Part VII):
Inside the Credit Crisis: How the Fed's Efforts to Lower the Fed Funds Rate May Leave it Powerless to Stop the Financial Meltdown.
Money Morning Special Investigation of the U.S. Credit Crisis (Part VIII):
How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis.
How Many ARM's Set To Reset in 2008…?
Money Morning News Analysis:
Paulson Announces New Plans to Buy Equity Stakes in Banks and Revive Credit Markets.
- Money Morning News Analysis:
By Relaxing "Mark-to-Market" Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?
Money Morning News:
Big Changes for LIBOR as BBA Tries to Restore Credibility in Key Lending Rate.
Money Morning News Analysis:
LIBOR Sends Another Shaky Signal to the Global Financial Markets.
Money Morning News Analysis:
Federal Reserve Joins Central Banks Around the World in Cutting Rates, but Is It Too Late?
About the Author
Shah Gilani is Chief Financial Strategist for Money Map Press and boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker. He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk and established that company's "listed" and OTC trading desks. Shah founded a second hedge fund in 1999, which he ran until 2003. Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see. On top of the free newsletter, as editor of The 10X Trader, Money Map Report and Straight Line Profits, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade using a little-known strategy. Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on FOX Business' "Varney & Co."