Libor Holds Central Banks Hostage as Credit Freezes

By Gavin Finch and Ben Sills

Oct. 9 (Bloomberg) -- Danilo Coronacion oversees 15 percent of global coconut oil production at CIIF Oil Mills Group in the Philippines. These days, he spends a lot of time worrying about events half a world away in London. The name of his pain? Libor.

CIIF has more than $60 million of debt, or 70 percent of its working capital, linked to London interbank offered rates that have soared since Lehman Brothers Holdings Inc. collapsed on Sept. 15. The cost of borrowing in dollars for three-months in London jumped 23 basis points today to 4.75 percent, the highest level since December.

Rising Libor, set each day in the center of international finance, means higher payments on financial contracts valued at $360 trillion -- or $53,500 for each person worldwide -- including mortgages in Britain, student loans in the U.S. and the debt of companies like CIIF in Makati City, the Philippines.

``You can't afford to be caught in the wrong position at any given time,'' said Coronacion, chief executive officer of CIIF, which generally pays 1 to 2 percentage points more than Libor.

Central banks from the U.S. to England and China cut interest rates yesterday in an attempt to restart the flow of credit and prevent a global recession. The moves came after they had funneled trillions of dollars into money markets in a failed bid to end the blockage. South Korea, Taiwan and Hong Kong lowered their benchmark rates today.

`Fear and Panic'

The process of setting Libor is overseen by the British Bankers' Association, putting it outside the domain of central bank policymakers. The overnight dollar rate fell 29 basis points to 5.09 percent. That's still 359 basis points more than the U.S. Federal Reserve's benchmark rate.

Libor, a gauge of bank funding costs, continued to rise even after Spain and the U.K. acted to strengthen their banking systems and the U.S. Congress approved a $700 billion financial bailout. Even the Fed's decision Monday to double emergency cash auctions failed to unlock short-term lending. The European Central Bank today offered banks as much cash as they need for six days at its benchmark rate of 3.75 percent, bringing forward new measures to soothe money markets.

``You get to a situation where fear and panic take hold,'' said Peter Dixon, a London-based economist at Commerzbank AG, Germany's second-biggest bank. ``This is the eye of the storm.''

Mysterious Acronym

Still, the jargony acronym Libor mystifies most people. While U.S. presidential candidates John McCain and Barack Obama have sparred over the economy and the mortgage crisis in America, neither has braved a public discussion of Libor.

Banks aren't lending because they're worried any borrower may become the next victim and they'll be left with losses as the credit freeze deepens.

Late on Oct. 7, as U.S. stock indexes tumbled to their biggest annual declines since 1937, AXA Investment Managers, a unit of Paris-based Axa SA, sent out an updated list of acceptable counterparties to about 50 of the firm's most senior investors and traders.

The memo, obtained by Bloomberg News, barred all new trading with Royal Bank of Scotland Group Plc and ABN Amro Holding NV, even if the dealings were backed by collateral.

`Speed of Light'

Money managers were also told to look for ways of cutting credit risk. Trading was also suspended ``even on a collateralized basis'' with banks including Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., American Insurance Group Inc. and Macquarie Group Ltd.

Axa Investment Managers CEO Dominique Carrel-Billiard yesterday said the memo was out of date.

``At any given point in time, there are buy lists, sell lists, inclusion lists and exclusion lists,'' any one list will not tell you much, he said. ``In the current environment, those snapshots age at the speed of light.''

Former Bank of England policy maker Willem Buiter said one way to stimulate lending may be for governments to guarantee interbank lending or act as the universal counterparty between banks borrowing for longer than overnight.

``It's quite possible, indeed likely, that unsecured lending will not return on any significant scale -- ever,'' he wrote on his blog on Oct. 6.

Money-market rates signaled the severity of the credit crisis 14 months ago when Libor began to diverge from central bank policy rates. That happened after Paris-based BNP Paribas SA halted withdrawals from three investment funds because it couldn't value assets tainted by the collapsing U.S. subprime mortgage market.

Aug. 9, 2007

On Aug. 9, 2007, the three-month dollar rate surged to 40 basis points more than the overnight index swap rate, a measure of what traders expect the federal funds rate to average. It had averaged 11 basis points, or 0.11 of a percentage point, between December 2001 and July 2007.

``If you had asked me 13 months ago, I'd have said we'd be over the worst by now,'' said Stuart Thomson, a money manager at Glasgow, Scotland-based Resolution Investment Management Ltd., which oversees about $46 billion in bonds.

Coronacion from CIIF Oil Mills, whose products are used to make cooking oil, beauty creams and biodiesel, says he remembers waking up to a more difficult world that morning.

`On Your Toes'

``We were already in a volatile market at that time, and the rising Libor made our business even more complicated so that you have to be on your toes all the time,'' he said. ``Our finance people had to work very closely with our traders, or it could have spelled disaster for us.''

CIIF's three treasury employees work in shifts around the clock with its three traders to monitor Libor, foreign currency exchange rates and coconut oil prices, which have been falling.

``We're all getting squeezed,'' Coronacion said.

Libor is set through a daily survey by the London-based British Bankers' Association. As many as 16 banks, including UBS AG, Citigroup Inc. and Bank of America Corp., report the rates they think they can borrow at in 10 currencies and maturities ranging from overnight to one year.

The concept of a centralized dollar rate set outside the U.S. emerged in the 1970s when the Soviet Union and Arab oil producers invested export revenue in London to prevent it from being confiscated by U.S. authorities, said Chris Golden, who worked for Credit Suisse White Field at the time and went on to head bond research for Lehman and Nomura International Plc.

Thatcher

The measure started as a series of rates quoted by four banks as a reference for floating-rate notes and syndicated loans, Golden said.

The BBA began producing the unified rates known as Libor in 1986, an association spokesman said. That made Libor the natural benchmark when then-Prime Minister Margaret Thatcher abolished many restrictions on trading in the U.K., leading to an explosion in the range of products on offer, said David Clark, former head of funding at European Investment Bank, the European Union's Luxembourg-based development bank.

While the estimates that go into Libor used to be based on actual transactions between banks, they have become little more than guesswork since credit markets froze, according to three people with knowledge of how interbank rates are set. They spoke on condition of anonymity because they weren't authorized to discuss rate setting.

`I Don't Know'

``Whatever answer you give is by definition wrong,'' said Meyrick Chapman, a strategist at UBS in London. ``There is no interbank lending, so the only proper answer to where could you fund yourself is `I don't know' or `I can't.'''

BNP Paribas's decision to halt withdrawals from the three funds in August 2007 crystallized investor concerns that events such as Merrill Lynch's seizure of collateral from two Bear Stearns Cos. hedge funds and Germany's bailout of IKB Deutsche Industriebank AG were part of a wider breakdown.

Libor rose as banks became wary that their counterparts might be holding subprime assets, and lending between institutions started freezing up.

That took its toll on Northern Rock Plc. The Bank of England bailed out the Newcastle, England-based mortgage lender in September of last year, after rising credit costs left it unable to borrow from its peers and depositors lined up to close their accounts.

Tensions in the credit markets eased in late December after the Fed joined forces with central banks around the world to pump hundreds of billions of dollars into the money markets to relieve a year-end funding squeeze. The respite proved temporary.

`Defensive Crouch'

Libor jumped again on March 17, after New York-based Bear Stearns collapsed when clients pulled $17 billion from the securities firm in two days and creditors stopped renewing loans.

Everything accelerated with the Sept. 15 bankruptcy of Lehman Brothers. The cost of borrowing in dollars for three- months has surged 1.7 percentage points in the past three weeks.

``It shows you again that people have gone into a defensive crouch,'' Federal Reserve Bank of Dallas President Richard Fisher said Oct. 6.

The difference between what banks and the U.S. Treasury pay to borrow money for three months widened to a record 413 basis points today. The so-called TED spread, which reflects perceptions of how risky it is to lend to banks, averaged 41 basis points in the 17 years to July 2007.

By comparison, on Oct. 20, 1987, when stocks collapsed globally on what became known as Black Monday, the spread was at 300 basis points. It peaked at 160 basis points after the hedge fund Long-Term Capital Management LP imploded in 1998.

Giving Up Cable TV

The spread charts and financial acronyms mean real pain for people like Maureen McNally of Trenton, Florida. The monthly payments on her Libor-linked mortgage from Countrywide Financial Corp. have climbed to $769 from about $500.

``I had to give up my cable television, I had to give up my house phones, because I had to cut back completely,'' said the 53-year-old gift processor at the University of Florida in Gainesville. ``I am so disgusted with this whole mortgage thing I never want to own a home again.''

McNally says she's had her house on the market for nine months without an offer.

Martin Zorn, the chief financial officer of Integra Bank Corp., said he's never seen so much volatility.

The Evansville, Indiana-based bank, which has branches in Indiana, Illinois, Kentucky and Ohio, is finding that rate quotes for loan proposals are now good only for the day they are made, not for two weeks as in the past, Zorn said. Half of Integra's loans and all of its deposit rates are tied to Libor.

`Very, Very Panicked'

``Everyone is very, very panicked,'' he said. ``A bunch of people are putting money in the mattress, which worries me.''

Central bank efforts to tame Libor have had little impact because instead of lending the extra cash, banks are holding it on deposit with the ECB at a loss. On Oct. 6, banks borrowed 13.6 billion euros from the ECB at its emergency rate, which then stood at 5.25 percent. At the same time, they deposited 42.6 billion euros overnight at 3.25 percent.

``Libor rates are now more or less meaningless because everyone is just doing business with the European Central Bank,'' said Jan Misch, a money-market trader at Landesbank Baden-Wuerttemberg, Germany's biggest state-owned bank.

ECB President Jean-Claude Trichet said banks are probably over-assessing the risks they are taking.

``They are going too far in the other direction,'' he said at an Oct. 2 press conference in Frankfurt. ``I call upon them to keep their composure.''

So far his calls have fallen on deaf ears.

To contact the reporters on this story: Gavin Finch in London at gfinch@bloomberg.net Ben Sills in Madrid at bsills@bloomberg.net