LIBOR and National Funds Rates -- How the Globalization of Markets Displaces Politics and Governments

Between hedge funds and mutual funds and international M&A activity, markets for credit and debt instruments have gone global.  As a result, what started as the sub-prime mortgage implosion in the U.S. has caused tightened credit across international financial markets. 

The money used to fund mortgage loans to otherwise uncreditworthy buyers was raised largely by reselling the mortgages in pieces on the secondary markets.  The idea, not unreasonable at the time, was that this spread the risk of default across a wide swath of secondary instrument buyers, each of whom held a diverse portfolio of slices of potentially bad loans.  Unfortunately the result in retrospect has been to spread the credit collapse across the world like a passenger with a bad cold on a long intercontinental flight. 

Large banks around the world wound up holding, either directly or through participation in hedge funds, enormous portfolios of securities whose net asset values were crashing as the underlying loans supporting that value went into default.  As banks saw their asset base declining, they tightened up their lending practices accordingly.  More than just tightening their lending of money, a couple of large banks, most notably in France and Germany, barred certain customers from even withdrawing their own money held on account -- often a sign of a real impending banking meltdown.

Tight credit leads to a corresponding decline in consumer and industrial spending in an era of borrow now and pay later budgeting.  And a sharp decline in private sector spending can quickly lead to an economy spiraling downward into recession.   Not surprisingly in the face of this prospect, and bolstered by nervous constituents about to see a cutback in their credit enhanced lifestyles, governments around the world are trying to loosen up credit markets in the hopes of keeping money on the street and the economic engine well-oiled.

The vehicle that governments use to accomplish this is to lower their equivalents to what in the US is called the federal funds rate, that is the rate which the central bank charges its national constituent banks to borrow overnight money.  By lowering the cost of money from the central bank, the expectation is that the constituent banks will borrow more money which can then be put out onto the street through a chain of loans to each banks respective customers.   

This all worked quite well of course so long as banking was largely a business that operated within national borders so that the principal source of new money to a country's major banking institutions flowed from that country's central bank.  Changes in the federal funds rate would cascade down through the system and each country's government could use this monetary control to ensure that its political / economic agenda was pushed out into the market place.

As with all these national policy constructs, a funny thing happened when the economy went global while governments remained national.    Large international banking companies, it tuns out, raise much of their capital through the trading of securities and purchasing of credit instruments (i.e. borrowing money) from other international banks.  Money flows around the world markets very much like every other good and service.  In order to regulate this commerce through a market price mechanism, international interbank borrowing is generally pegged not to an individual county's federal funds rate equivalent, but to the London Interbank Offered Rate or LIBOR. 

LIBOR is essentially the interest rate charged by banks on short term loans made to each other.  The rate is set daily by a distinctively private sector institution, namely a British banking trade association.  It has become so widely accepted as an international standard for the cost of short term money, that the published rate is also used as a bench mark for a wide variety of private financial transactions, from intra-company lines of credit to adjustable rate mortgages.

Here is the rub -- when lending money gets riskier, in a free market, the cost of borrowing money goes up to adjust for that added perceived risk.  Thus, while government controlled central banks are lowering rates in an effort to ease credit, LIBOR which is a private market based rate is going up to reflect the fact that all these defaults are making credit more risky than previously perceived.  And since so much money flows through international financial markets based on LIBOR pricing rather than the federal funds rate, the increases in LIBOR may well offset any efforts that governments are making at easing credit markets and increasing the flow of funds.

Somewhere here lies a fundamental philosophical question -- i.e. in the long run, are we better off responding to problems like the subprime mortgage mess by having prices reflect changes in supply and demand in private markets or by having prices reflect the government's view of sound political / economic policy (the government being made up of learned experts or bureaucratic buffoons depending on your personal point of view).  Then again, as with many other such questions, the seemingly inevitable globalization of markets may have rendered our individual answers to such questions largely irrelevant.

[Note of Attribution: This post as with most is an application of my thinking over the past couple of months around a plethora of articles and sources on the subprime mortgage mess and the reactions of central banks and financial markets.  To give credit where credit is due, however, the immediate inspiration to get it down in a blog post came from an excellent article on the subject that appeared in this past Wednesday's Wall Street Journal entitled "Why Libor Defies Gravity: Divergence of a Key Global Rate Points to Strain".]