How Libor Became a Fixture Of the U.S. Financial System

Libor—yet another acronym to make recent headlines. It denotes the London interbank offered rate, and since its birth in the mid-1980s, it has become the primary benchmark by which an estimated $350 trillion of worldwide financial products, including a healthy chunk of the U.S. mortgage market, has been priced.

It's precisely because of its sprawling global reach that, when controversy surfaced this past summer over accusations of Libor manipulation, the U.S. paid strict attention. The broader impact of the Libor disgrace was to spawn more suspicion over the probity of the financial markets, precisely when confidence in the industry was at a low point. Weighing in on the unfolding drama, Federal Reserve Chairman Ben Bernanke was widely quoted as pronouncing the Libor system "structurally flawed."

The brouhaha now begs the question: How did the U.S. market for so many products get so dependent on a rate first set in London close to 30 years ago?

To answer that, a bit of history.

The first Libor data was published by the British Bankers' Association in January 1986, as the benchmark for a burgeoning, London-based market where overnight to one-year loans were issued. With so many banks engaged in these loans, plus foreign currency trading, the association (Thomson Reuters does the current calculations) determined a benchmark meant to reflect the average cost at which 18 big banks would borrow U.S. dollars from each other. The final daily rate was calculated by polling the banks, tossing out the four highest and four lowest figures, and taking the average of the 10 remaining rates to determine Libor-posted daily at 11:30 a.m., London time.

As major American banks began funding themselves more in the London markets, lured by the availability of Eurodollars and lighter regulation than what was enforced at home, they started migrating toward a Libor-based environment.

"Without a doubt, U.S. banks realized that the main market for money had clearly shifted to London and they simply had to go along with using that London-based Libor rate," confirms Richard Sylla, a financial historian and professor at New York University's Stern School of Business.

Starting in the mid-1990s and into the early 2000s, major U.S. banks grew even more dependent on Libor (gradually supplanting Treasury rates) as a benchmark for issuing popular adjustable-rate and subprime mortgages-especially as the housing bubble gained momentum.

Today, according to a study by Guhan Venkatu, an economist with the Federal Reserve Bank of Cleveland, around 45 percent of prime adjustable-rate mortgages are pegged to Libor, based on a May sample, with close to 80 percent of subprime mortgages overall tied to the index. A typical adjustable-rate mortgage might be priced at six-month Libor plus two or three percentage points.

"With Libor being the most widely used private sector benchmark out there," says Michael Fratantoni, a vice president of research at the Mortgage Bankers Association, "it became, starting in 2000, the natural leading alternative to the one-year Treasury rate, which had been the common index for most adjustable rate mortgages."

Libor's almost inevitable wedding to the exploding adjustable-rate mortgage market "was really a natural occurrence," says Darrell Duffie, professor of finance at Stanford University's Graduate School of Business. "Because as everything was benchmarked to Libor, it became easy for banks and other investors to hedge their positions against mortgages by using derivatives, as swaps or Eurodollar futures, all of them pegged to Libor. Soon enough, American banks considered Libor to be such a reliable gauge of interest-rate levels that it could have the mortgages benchmarked to them."