LIBOR, the London Interbank Offered Rate is set daily as the cost of short term borrowing between banks. Quoting LIBOR is all the rage at the moment, it even gets a mention on the national news these days. The question is why? 

What’s LIBOR got to do with everyday life or investments? Like any interest rate, LIBOR is based on a fairly simple premise. If you borrow money, you pay the lender compensation. The lender may also want to build in a risk premium, a bit of insurance on each transaction to help cover for the time a borrower defaults on a repayment. If the economy is ticking along nicely, with plentiful liquidity the chances of default on a repayment is remote, with the chance of a default on the principal unthinkable. The banks are happy to lend, not only to each other but to anyone who can qualify for a loan. Standards don’t even need to be too tight, not with nearly everyone making money or holding appreciating assets.

During these halcyon economic days the banks can relax, they can lend at lower rates as returns are healthy and risk is deemed low. Its also very easy to use the full capital of the bank in the pursuit of returns, no bad thing in these days of financial innovation. Even if the capital becomes a bit tight, the bank can borrow from another to ensure capital reserves are met. Some banks even borrowed short term money at LIBOR and used it to finance long term loans, rolling the short term debt into another loan as it matured. I’m sure some of you can even remember mortgages being offered at LIBOR plus a small percentage.

LIBOR could be viewed as a measure, quantifying the confidence banks have lending to each other and the financial system as a whole.

So why is LIBOR in the news now? Simply put, the rates have gone higher, much higher of late. The confidence banks once had in lending to each other has evaporated. With the Bank of England base rate at 5.75%, sterling LIBOR (as well as euro and dollar rates) has now risen to one percent higher, with the one month rate now at 6.749%. Although the overnight rate has dipped slightly, the three month rate also continues to climb, sitting at 6.649%, just 1/10^th of a percent lower. Which means confidence in other banks and in the financial system is not going to make a quick comeback. Banks seem much more interested in keeping their own capital in the vaults than lending it out, probably to ensure that they can replenish their own capital reserves to help cover losses in those debt instruments of financial innovation.

Its not just interbank lending that comes under pressure. A recent Dow Jones byline showed that banks have asked corporate customers not to draw on approved lines of credit. Mortgage lending too is much lower, by 14%, than this time last year. Standards on consumer loans and credit card approvals have also increased. Banks do not want to lend. In a financial system, reliant on the use of debt to generate earnings, the banks must see a risk that makes the reward of hoarding cash and rapidly reducing business attractive.

From an investment point of view, maybe its time to look at which banks are overstretched and, more importantly, which companies are heavy users of debt. Those that have been prudent may well offer a more attractive outlook.

It might just be that for the next few months the term rollover might be restricted to the lottery jackpot.

Market Snippets

As well as HSBC having to pump cash into a couple of SIV’s last week, West LB also had to top up another of it off balance conduits, which would make it more “on balance” than off it seems. A month after pumping $3bn into Kestrel, a smaller conduit, it has now had to provide a credit line to Harrier Finance, this time for $11bn. Its not even an investment as such but like many of these actions carried out by various banks, this credit is just to enable Harrier not to have to sell asset backed securities at a loss.

It might be time to keep an eye on Africa. IBM announced a large investment, expanding its activities in Sub-Saharan Africa by $120m and a recruitment drive for up to 100 students.

There seems to be a more vocal approach toward UK interest rate cuts from the markets this time around, with one or two people calling for a 0.5% cut to help head off tightening credit conditions. In the main though the outside bet is for 0.25% with most expecting no change. In the US, Fed Fund futures have been moving of late, pricing in a 50-50 chance of a 0.5% cut at the next meeting.

Commentary by Mick Phoenix

on behalf of An occasional letter from The Collection Agency

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. The views in the article are for informational purpose only.