By now we all know that trillions of dollars of securities and payments on consumers loans like mortgages and student loans are tied to the once-obscure London Interbank Offered Rate, or LIBOR. But why? Why should the payment on an adjustable rate mortgage in Lincoln, Nebraska, be determined by the rate the world largest banks charge to lend to one another in London, England?
It all comes down to hedging.
Banks usually own tons of bonds and other securities issued by private borrowers. And the value of those holdings fluctuates with interest rates. But bond prices and interest rates move in opposite directions. So if interest rates rise, banks stand to lose billions as the value of their bond holdings falls.
To protect themselves from that happening, banks often hedge. In other words, they find something in the financial markets that pays them if interest rates rise. So they tell their traders to wade into the financial markets to find that something. And the main way they’ve done that is in the futures market, i.e., placing a bet that the interest rate on something will rise in the future.
At first, one of the most popular bets of this sort was on the interest rates on US Treasury bills. Under normal circumstances, this interest rate—which reflects the cost of short-term US government borrowing—tends to move in lockstep with the rates for private entities like corporations. And since a rise in the rates makes the banks lose money, betting on a rise in the rates for Treasurys—so that when Treasurys rise, the banks make money—can offset some of the losses they will see in their warehouse of securities. As long, that is, as Treasury rates and rates for private borrowers stay in sync.
But they don’t always. For instance, when there’s a real panic in the financial markets, investors rush to the safety of US Treasurys—which pushes down Treasury bill rates—and away from anyone that looks riskier, like private borrowers, pushing private rates higher. In other words, during periods of extreme fear, rates on Treasurys would fall just as rates everywhere else continue to jump.
That’s the worst of all outcomes for the banks. It means the value of their warehouses of private securities and bonds falls AND they are losing money on their hedge. Double fail.
Those painful double fails have happened a bunch of times in recent decades, from the collapse of once mighty Continental Illinois in the 1980s, to the failure of giant hedge fund Long-Term Capital Management in the 1990s to the most recent panic in 2008.
So this is where LIBOR comes in. Over time, bankers have realized that they need a hedge that tracks rates private entities pay all the time, not just some of the time. And over time they’ve gravitated away from US Treasurys to something called eurodollar futures, which are essentially bets on the future direction of LIBOR. That futures contract appeared in the early 1980s in the US, and offered banks a key advantage over hedging with Treasurys—the key one being that if there’s a panic in the financial markets, LIBOR rates will rise along with other private rates, and the bank is protected on its hedge.
And here’s the thing about financial markets: As more and more people traded the eurodollar contract, that increase in buying and selling made it cheaper and cheaper to trade. Banks like that. Over time, because banks have found it so easy to hedge using the eurodollar contract—essentially LIBOR—they’ve tried to make LIBOR the benchmark for more and more of the floating debt they offer to regular people, such as mortgage holders and students that need loans.
Why not? For the banks it makes it incredibly easy for them to hedge. And traditionally, borrowers didn’t really care.
Of course, now that’s changed. The specter of traders guffawing over their ability to manipulate Libor has tainted the rate in the eyes of many people. That’s why officials are publicly saying that some other benchmark should be found. But don’t hold your breath. LIBOR is so deeply embedded in the financial system, it will take a long time before another rate rises to prominence.