Monday, October 29, 2012

LIBOR Part II: Interest Rate Indexing

Worldwide Benchmark
LIBOR is used around the world as an index to determine other interest rates.  One interest rate often pegged to LIBOR that is most familiar to people is the adjustable-rate mortgage (ARM) rate.  After a fixed-rate period, ARMs reset to a floating rate and each year are subsequently changed based upon changes in the index rate.
There are a variety of interest rates to chose from when indexing an ARM.  The most common of which are LIBOR and short-term US treasury rates (constant maturity).  To create the floating rate, lenders will add a margin to the index rate; ceilings, floors and annual caps are written into the contract to further determine the floating rate.
Lockstep Movement
LIBOR and short-term US treasury rates behave in similar fashion.  The way one rate moves, the other has the same relative movement.  They track each other's motion well, from the 30-year downward trend to the 2008 dead cat bounce.  Since the 2007-2008 financial crisis the spread between the two has widened.

LIBOR and short-term US treasury rates show tight movement, but have widened since the dead cat bounce in 2008.
LIBOR and the 2007-2008 Financial Crisis
Subprime ARM defaults gained notoriety for their crucial role in the financial crisis.  Their losses alone were not large enough to bring down the financial sector.  However, when packaged into complex securities with default swaps the subprime crisis created a sort of perfect storm.
During the 2007-2008 financial crisis, the prices of these securities fell dramatically and the insurance payments on default swaps grew very large.  This happened for a number of reasons: poor understanding of risk, poor understanding of complex securities, credit downgrades of bond insurers, etc.  However, defaults in the subprime market acted like a flash flood.  Many of these subprime defaults were ARM defaults - many of them indexed to LIBOR.  The mark down of  subprime-backed securities caused a crisis of confidence in the repo market.

Mortgage delinquency rate increases lagged LIBOR and treasury interest rate increases by about 1-2 years.  The delinquency rate flattened 2 years after rates hit their bottom.

Other Uses
The 3-month LIBOR is indexed to the Chicago Mercantile Exchange's (CME) Eurodollar future contract.  LIBOR is also used by state and municipal governments to borrow money, and was used as an index in the Term Asset-Backed Securities Loan Facility (TALF) during the American bailouts.  LIBOR is also used heavily in swap agreements - some of which help bring down interest rates for fixed-rate and floating-rate borrowers.

No comments:

Post a Comment