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Boring But Important

07/16/2013

The London Interbank Offered Rate or LIBOR was designed to measure the cost of borrowing between banks in London when they borrowed overnight to cover minimum liquidity requirements.  The rate would increase whenever the banking system had too little liquidity or too little cash-on-hand.  It was an early-warning-system for the Bank of England that it might need to increase liquidity by increasing the money supply.

About the same time, another strange currency developed, i.e., Eurodollars.  When the U.S. first became THE world currency, many businesses around the world needed dollars.  American sellers didn’t want Greek drachma, for example, in payment for their exports to Greece.  They wanted dollars, which buyers had to buy before they could import goods from the U.S.  As they did more business with U.S. exporters, foreign businesses began accumulating dollars, which were held outside the U.S. and became known as Eurodollars.  However, the number of Eurodollars really increased during the Cold War, immediately following the Berlin airlift, when the Soviet Union was afraid the U.S. would confiscate their holdings of dollars in the U.S. and moved all those dollars, initially to Paris, as Eurodollars.

The next evolutionary step was that foreign businesses no longer had to buy dollars before doing business with U.S. companies.  Soon, they could borrow dollars.  But, what interest rate would they pay?  Over time, LIBOR rates became the primary interest rate measure for these Eurodollars.  Estimates on the amount of assets, including home mortgages and derivatives, whose value is partially determined by LIBOR vary from $350 TRILLION to $500 TRILLION.  I suppose it is natural that such enormous amounts might attract some ethically-challenged folks?

Remember, if LIBOR goes up, home buyers have to pay more on their home mortgages.  If those rates go down, the retirees who bought mortgage-backed securities receive a smaller amount of income.

LIBOR is announced by a consortium of banks who theoretically call each other daily and ask “hey, what were your funding costs last night?”  Keeping this rate low obviously had a positive impact on bank stocks.

The latest news is that London bankers considered themselves too ethically-challenged to continue maintaining LIBOR.  Last week, it was announced that the all-important rate would now be maintained by a U.S. firm instead.  I guess they think Americans are never ethically-challenged ?

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