LIBOR Liars

By Fester

About a month ago, I noted the problems with the London Interbank Overnight Rate (LIBOR) which is the price of money banks charge each other for short term loans.  The numbers were looking to be junk as banks were lying about their costs by understating the rates they were paying.  And this would lead to several significant problems.  The most apparent would be an increase in adjustable rate mortgage costs as half of American ARMs are tied to the LIBOR rate, but more systemically, it was a symptom of a fouled up credit market:

Good, reliable and trustworthy information is critical to making consistently good decisions as evaluated from a process perspective.  Good information in an effective decision and analysis system will lead to a higher probability of good outcomes.  Intentionally feeding garbage into a decision loop is an excellent way to create bad outcomes...

If lenders begin to not trust the LIBOR numbers, they will move their rate indexes to other indexes or raise the allowable spreads in order to compensate for what is perceived to be the 'real LIBOR' rate. 

However those types of interest rate and interest spread adjustments will quickly fail as the garbage in the information loop drives out good data and good money.  What was once a decision to offer a loan on a set of mutually agreeable conditions that were shaped by quantifiable risk is moving towards guesstimates and ass covering as uncertainty takes over.  Risk is defined as known probabilities of a loss.  A higher interest rate can be calculated to assure a reasonable expectation of profit for a given risk.  However uncertainty is unknowable and therefore incalculable.  When uncertainty dominates a system, the rational, profit seeking response is to get the hell out of that arena. 

Bloomberg reports that the garbage truck is arriving and is picking up the crap information through the form sanctions and banning of access to cheap credit:

The BBA, an unregulated London-based trade group, sets Libor by polling 16 banks each day on the rates they pay for loans in dollars, British pounds, euros and eight other currencies. The association is under pressure to show the rates are reliable following complaints by investors that financial institutions weren't telling the truth....

Libor rates jumped after the BBA said April 16 that any member banks found to be misquoting rates will be banned. The cost of borrowing in dollars for three months rose 18 basis points to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze last August.

This is a good step.  Driving out uncertainty and replacing it with risk reduces counter-party and trust risks.  Relying on good data even at the cost of slightly higher interest rates means more deals can be done as the data reflects reality and not fantasy.