LIBOR, or the London Interbank Offered Rate, was the most important acronym most investors never heard of before 2008. However, it quickly became the most critical variable in markets leading up to the Great Recession.
What has now become clear is that we haven’t learned any lessons from the financial crisis except how to accumulate more debt and to artificially control markets more extensively. And, to conveniently try to sweep under the rug the very same warning signs that forebode the day of reckoning just over a decade ago.
In layman’s terms, LIBOR is the average interest rate required by leading banks in London to lend to one another. It originated in 1969 when a Greek banker by the name of Minos Zombanakis, arranged an $80 million syndicated loan from Manufacturers Hanover to the Shah of Iran. Zombanakis constructed the loan using reported funding costs derived from a group of reference banks in London. Other banks began tying debt to this rate, and by the mid-1980s the British Bankers’ Association took control of this new rate that we now refer to as LIBOR. Today, the banks that encompass the LIBOR panel are the most significant and creditworthy in London.
LIBOR performs two major purposes for today’s markets. First, it serves as a reference rate used to establish the terms of financial instruments such as short-term floating rate financial contracts like swaps and futures. It also serves as a benchmark rate–a comparative performance measure used for investment returns.
Common sense would tell you that an increase in the LIBOR implies that those top banks comprising the LIBOR panel believe that lending to their fellow financial institutions is becoming riskier; with a significant spike signaling the possibility of economic instability. LIBOR rang an ear-piercing warning bell at the onset of the 2008 financial crisis. Before mid-2007, LIBOR trended with other short-term interest rates such as Treasury yields and the Overnight Index Swap (OIS) rate. But in August 2007, that relationship began to break, signaling the start of liquidity fears that drove the 3-month USD LIBOR up to 5.62%, from its average of 5.36%. During the same period, the overnight Fed Fund’s policy target rate for the Federal Reserve remained stable. Therefore, the spread between where traders believed the Fed Funds Rate would be and the rate banks would lend unsecured funds to each other started to blow out.