I’ve been reading a bit about LIBOR, which is one of the most important and powerful numbers in the world.

It’s also highly suspect.

LIBOR or the London Inter Bank Offer Rate, is the primary benchmark for short-term interest rates around the world. It is the rate at which banks are supposed to borrow from each other.

It is difficult to understate its power. It is used to settle $10 trillion worth of lending transactions, including corporate loans, adjustable-rate mortgages, private student loans and so on. Half of all adjustable-rate mortgages in the United States are set to LIBOR.

LIBOR is also used to settle contracts in what is arguably the biggest market of all, the interest-rate swap market. Notionally, the value of those trades is about $300 trillion.

These swaps sound esoteric, and they are, but they are the vitally important lubricant to our banking system, which as you might have heard isn’t working so well these days. Interest-rate swaps are the oil in the credit engine, serving as a hedge against changes in interest rates. Without them, banks would be less likely to borrow at a floating rate (Libor/Federal Funds) and lend fixed-rate mortgages.

The problem is that LIBOR is not a market rate of interest. It is compiled by the British Banking Association in conjunction with Reuters and released to the market shortly after 11.00am London time each day. It is essentially a poll of the rates charged by 16 U.S. and non-U.S. banks. According to the London Review of Books:

The calculation of Libor is co-ordinated by just two people, who work in an unremarkable open-plan office in London’s Docklands. I watched the process, which seemed utterly routine, a couple of years ago. Just after 11 a.m. on every weekday that’s not a bank holiday, traders at leading banks send in their estimates of the interest rates at which their banks could borrow money. They do this electronically, but sometimes the co-ordinators make a phone call to a bank that hasn’t sent in its estimates, and if the latter seem implausible – typos, for example, are fairly common – they’re checked, also with a quick call: ‘Hi there, is the Kiwi chap [provider of the estimates for borrowing New Zealand dollars] about? . . . Bit of a spread on the two month. Everyone else is coming in a good bit under that.’

Bankers have quietly begun to question whether this is really the best way to do things. The Bank of England reported that some lenders raised concerns in November 2007 that banks were manipulating LIBOR. So did the Bank for International Settlements, which is sort of the central bank central bankers.

“The LIBOR numbers that banks reported to the BBA were a lie,” said Tim Bond, head of global asset allocation at Barclays Capital in London. “They had been all along. The BBA has been trying to investigate them and that’s why banks have started to report the right numbers.” (Bloomberg)

Why would banks lie?

“The most obvious explanation for Libor being set so low is the prevailing fear of being perceived as a weak hand in this fragile market environment,” wrote Scott Peng, head of U.S. rates strategy at Citigroup in New York. (Bloomberg)

In other words, banks are desperate from cash, but they are hiding this fact to prevent a panic.

The BBA did a review of how it calculates LIBOR, but critics like First Capital’s Mark Sunshine, a commercial lender, says that nothing really changed. LIBOR remains flawed:

Numbers can help to put some prospective on this issue. Assuming that LIBOR is off by 0.01% (i.e., 1 basis point), United States consumers and businesses will either pay too much or too little interest by approximately $100 million per day (or approximately $35 billion per year). However, when the question of LIBOR accuracy was raised it appeared that LIBOR was off by more than 0.25%. That means that interest rates were being mischarged by approximately $2.5 billion per day or almost $1 trillion per year.

The Wall Street Journal reported that the British Banking Authority is hesitant to change how LIBOR is calculated because it is worried about astronomical levels of legal liability. Admitting that British banks were colluding to set LIBOR much as OPEC colludes to set oil prices, would trigger a flood of global lawsuits resulting from fraudulent behavior and misrepresentations.

Sunshine concludes:

LIBOR and the BBA remind me of a saying that I have often heard from Eastern European business people, “Everything the Communists told us about communism was a complete and utter lie. Unfortunately, everything they told us about Capitalism turned out to be true.”