In an unremarkable office block somewhere in London’s Docklands a small band of people are charged with producing perhaps the world’s most important number. The level of that number, fixed at 11 o’clock each morning, will have far-reaching consequences throughout the world: it will send some into bankruptcy, make others millions. It is a part of the very foundations of capitalism. And yet very few people outside the financial markets even know about it. It is the London Interbank Offered Rate (Libor).
The Libor rate, which is administered by the British Bankers Association, sits at the hub of one of the key sectors of the world economy—the money markets. It is here that companies borrow and lend money in the short term—in other words, without having to issue bonds or equities (see Bond markets). These markets are the central nervous system of the world’s financial system, and when, occasionally, they fail, it can send the entire economy into shock.
In normal times, Libor simply reflects the rate at which banks are willing to lend to each other in the short term. This lending—often referred to as interbank lending—is unsecured: it is rather like an overdraft or credit card as opposed to a mortgage, and is essential for banks to function. Every day, a bank’s balance sheet changes significantly as people deposit, withdraw, borrow and repay cash, and so being able to borrow from one another at short notice is essential for banks to stay afloat.
The way in which banks operate has undergone various transformations over the past decades. Traditionally, banks would make their money by taking in customers’ deposits in the form of savings and lending out this cash to other customers as mortgages and other types of loan (see Banks). On the one hand this meant that, rather as George Bailey (played by James Stewart) attempts to pacify depositors who are frantically withdrawing cash in It’s a Wonderful Life, the banks had a direct connection—often a personal relationship—with their customers. On the other hand, this modus operandi didn’t provide the banks with as many opportunities for growth as they wanted because there were rules laid down by regulators about how much they were allowed to lend in comparison with their size. This, in turn, meant they weren’t as likely to charge low mortgage rates.
The power of Libor
So powerful and expansive have the wholesale money markets become that the London Interbank Offered Rates—which are broken down into the world’s major currencies including the dollar, euro and sterling—are at the heart of contracts worth around $300 trillion—equivalent to $45,000 for each human being on the planet. Most people think of interest rates as the official rate laid down by central banks such as the Federal Reserve or Bank of England. In fact, Libor is a far better indication of the real cost of borrowing in the broader economy.
Rise of securitization Many of these banks, or mortgage lenders, were set up as mutual associations, meaning they were owned not by shareholders but by their customers. In the UK, such specialized mortgage lenders were known as building societies, and included companies such as Nationwide and Northern Rock.
However, in the 1970s and 1980s, as demand for home ownership grew (see Home-owning and house prices) and banks realized it would be difficult to keep up without boosting the amount of cash they had available to lend, they turned to an alternative system. Rather than lending cash based solely on their deposits, they started to bundle up the mortgage debt they were issuing into packages and selling it on to other investors. The process was known as securitization—because it turned debt into securities (investment instruments such as bonds, options, shares, etc.)—and worked very well for a time. By taking the mortgage debt off their books, the banks were able to lend out more and bigger mortgages without being limited by their size. Investors from around the world queued up to buy the securities, lured by the healthy return the securities paid and the reassurance of credit ratings agencies that they were reliable investments.
Over time, banks have become increasingly sophisticated in how they create these securities. Not only have they bundled mortgages together into packages; they have also sliced and diced them into instruments known as collateralized debt obligations (CDOs), and even more complex versions such as CDOs2 (effectively sliced and diced twice) and CDOs3 (cubed).
The theory behind such activities seems quite sensible. Previously, if a mortgage holder defaulted on his debts, the main party to suffer would be the bank; securitization promised to spread that risk around the financial system to those more willing to take it on. The problem, however, is that by eliminating the personal relationship between borrower and lender (a process called disintermediation), there is a far greater likelihood that whoever ends up buying the package of debts—whether they are Japanese investors or European pension funds—will not appreciate the true picture of the risks they are taking on. All they have to rely on are the ratings handed down by agencies such as Standard & Poors, Fitch and Moody’s, and so on.
This disconnection was one of the main causes of the financial crisis of the 2000s, since investors were not fully aware of the scale of risk they were taking on when they bought such immensely complicated bundles of debt. Since banks were lending out far more than they had in deposits, they developed a major shortfall in their accounts—a hole widely known as the funding gap—which can only be filled by wholesale funding. As we will see, this was not forthcoming.
The day that changed the world On August 9, 2007, both interbank markets and markets for securitized mortgages seized up suddenly all around the world. Realizing that the US housing market was facing a major slide, and that, more fundamentally, the Western financial system had become excessively indebted, investors stopped buying securities—in other words, they stopped lending money. It was a moment of fear that triggered the financial crisis to follow; the moment when economists and financiers, who had until then paid this complex part of the system scant attention, realized its importance to the health of the world economy.
“I don’t think that any economist disputes that we’re in the worst economic crisis since the Great Depression. The good news is that we’re getting a consensus around what needs to be done.”
Barack Obama
Many banks on both sides of the Atlantic, including Northern Rock, were suddenly unable to fund themselves from the wholesale markets. They were left with a massive black hole in their accounts. Although the financial crisis had many causes, it was this freeze in the financial markets that sent the first fatal shocks through the system. Barely a month later Northern Rock was forced to seek emergency funding from the Bank of England, which acted as a lender of last resort. Although many assume that the problem was caused specifically by subprime mortgages (i.e. home loans made to people of low creditworthiness), the real issue for Northern Rock was that it was so entirely reliant on the wholesale markets, where Libor rates had shot up, reflecting banks’ reluctance to lend to each other.
The Libor rate is only an indicative rate, showing what banks would in theory be willing to charge each other. In this case, there was no lending occurring whatsoever. Central banks were forced to step in and pump money directly into markets and banks themselves. The money markets had dried up!
the condensed idea
Money markets make the financial world go round
| timeline | |
|---|---|
| 1970s | Securitization first developed |
| 1984 | The British Bankers’ Association sets up Libor |
| 1980s–90s | Banks around the world expand rapidly |
| 2007 | Interbank markets freeze up |