The Low-Down on Libor: Why its Surge Signals Desperation in the Credit Markets

The scoop on this oddly named benchmark.

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Turmoil in the credit markets has pushed Libor—the London interbank offered rate—to an all-time high, according to the British Bankers' Association.

So what exactly is Libor, and why is this significant?

Libor (pronounced LYE-bor) is an interest rate set in London each business day. It's the rate at which banks lend to other banks that need temporary funds, by way of the London interbank market. This benchmark is significant because it represents the rate at which the world's most preferred borrowers are able to borrow money, and it's also a widely used reference point for short-term interest rates.

After the rejection of the bailout bill by the House of Representatives, banks hoarded cash, driving Libor up to 6.88 percent. A week ago, Libor was at 2.95 percent. (Normally, it's slightly more than the Federal Reserve's target fed funds rate.) Points out MarketBeat: "It's more than a little ironic that while investors are buying banks' stocks—shares were up sharply across the sector—banks themselves were unwilling to buy each others' shortest term debt. Banks are so desperate for funds that they paid 11% for $30 billion in overnight funds from the European Central Bank, up from 3% just Monday."

The Associated Press answers the million-dollar question: So how does this affect my life?

A. More than half of U.S. adjustable rate home loans are tied to Libor, so a recent increase in this benchmark rate mean monthly mortgage payments will rise for affected homeowners if the rise is sustained. A typical adjustable rate home loan will adjust based on the six-month Libor, plus 2 to 3 percentage points. Plus, many home equity lines of credit, small business loans and student loans also use Libor as an index. Student loans, for example, can be set based on the three-month Libor rate plus, say, 4 percentage points or the one month Libor rate, plus 9 percentage points.

Meanwhile, The "TED spread"—which represents the difference between what banks charge each other to borrow for three months and what three-month U.S. treasuries yield—surged to its highest level in more than 25 years Monday. (It has since retreated from that high, dropping from 3.54 percent to 3.04 percent.)

Here's a more on the Ted spread.