LIBOR rates have plummeted since the start of the credit crisis last fall to levels unseen since the last recession in 2003. As they continue to fall, showing strength in the amount of credit available, banks have become more willing to borrow and lend, producing rather large profits at current mortgage rates.
Why LIBOR is so Important
If nothing else, LIBOR rates are one of the best indicators of an ending recession. When the LIBOR rate falls, it shows that there is enough capital to borrow and loan between banks, and some speculative bankers can show a profit by borrowing low and lending high. At present, the 12 month LIBOR rate sits at just 1.9%, while 30 year mortgage rates are just over 5% at 5.2% per year. Using a very general example, Bank A could borrow money from Bank B at 1.9% then lend it to the consumer for 5.2% per year. The difference, 3.3%, is the bank's profit, pending that their loans do not go bad and that the borrower can continue to make payments. When the spread becomes large enough, banks are more willing to make leveraged bets on behalf of their depositors to earn additional money on the amount of the float, or the amount of money that the bank currently has to deploy.
Investment Banks are Pivotal
It is investment banks, not savings and loan banks, that make the LIBOR rate incredibly important to the health of not only the credit markets, but also the debt markets and stock markets. Investment banks, when able to borrow at such low rates, are able to flip incredible amounts of debt to reap extreme rewards. In some cases, banks can borrow at the rate of 1.9% and then invest the money in corporate debt, or for riskier investors, junk debt to rev up profit margins. Right now, junk bonds are yielding on average nearly 15% per year for the end purchaser. Were an investment bank to borrow $1 million at 1.9%, it could then loan the money out for as much as 15% and make a 13.1% profit just by servicing the debt. In this case, the profit would be $131,000, which is a decent return considering it was not made with your own money. Any profits generated on borrowed money are excellent because the power of leverage makes the return that much more great. The initial investment by the bank is virtually zero; in no way do they put any money down, instead they capitalize on the idea that the loans will not go sour and that their basket of investments is 100% secured.
There are no Guarantees
Leverage is great when times are good, but it's twice as bad when things go wrong. Case in point is what happened six months ago at the height of the credit crisis. Many banks were over-leveraged as a result of borrowing too much from another bank to loan to someone else who can no longer make payments.
Generally debt is very liquid; one bank can take a loan and sell it on the open market to another who will then service the debt and earn a profit on the difference. In this case, however, the value of debt plummeted as mortgage-backed securities fell out of the interest of investors. If an investment bank were to buy $1 million of debt which yielded 10% and paid just 2% to borrow the money, it would earn $80,000 per year with other people's money. However, debt trades inverse to its yield, and as such, when the perceived value of the debt goes down, the interest rate goes up, but the owner of the debt loses paper wealth for what the debt was worth. This is when things go horribly wrong.
When Payments Stop
When the money stops coming in, or when investors fear it may soon stop, the value of the debt drops because not all of it will be recovered. That $1 million in theoretical debt may fall to a value of $600,000 on the open market, effectively now producing an interest rate of 16%. Were the bank to sell the debt, it would be left holding the bag for $400,000, which must now be paid to the other bankers who lent the money at a 2% rate. Holding on to the debt poses the risk that you may lose far more than $400,000, and thus, selling it may be a good idea. Either way, the loss is recorded, and when the accounting rules were different, the bank's paper loss of $400,000 would become real, at least on the accounting books.
LIBOR in the Future
Now that the LIBOR rate is coming to a point at which banks are willing to accept risk, it will play a key fundamental role in propping up the stock markets. Since banks have covered their bad loans through government subsidies, the next step is to make new, quality loans that will generate profits. With rates so low, corporations and other enterprises will be able to expand and refinance debt at lower rates to become more competitive.
Rates Must Stay Low
One huge dip in the LIBOR rate is unlikely to have any long-lasting effect on the market. Though it may give a temporary boost, as it did in March, an extended period of time with extremely low rates is what truly pushes the market forward. If rates stay moderately low for the next five to six months, expect a widespread rebound; otherwise, the recent movements will be recorded as nothing more than a blip in the chart.