For U.S. bankers, it is easy to ignore the London interbank offered rate when times are good. Now is not one of those times.

In the past few weeks, Libor — the influential composite of short-term borrowing costs for some of the world's largest banks — has risen sharply, reflecting Europe's debt tremors.

For consumers, in turn, the spike adversely affects a variety of loans in this country, not least of all home mortgages; the index is the primary benchmark used to determine rates on most jumbo loans now issued, and it underlies many of the subprime loans issued during the boom. Libor's fluctuations also determine the monthly rates on many commercial loans here.

With the U.S. economy showing signs of a fledgling recovery, some now question whether it makes sense to enmesh the loan rates of U.S. homeowners and small businesses with the ill health of European financial institutions and governments. Compounding this, the European turmoil has also revived concerns about Libor's fundamental accuracy.

In a crisis that should be disproportionately affecting European institutions, the individual borrowing costs self-reported by the 16 banks that contribute to Libor have risen in near-lockstep. As the crisis worsens, this is creating seemingly implausible results.

According to the daily Libor survey, it is now safer to make a one-year loan to France's Societe Generale than it is to the Royal Bank of Canada , an institution whose home country is generally held to have made it through the financial crises of recent years with flying colors. Though the European contributors do report slightly higher borrowing costs on average than their non-European counterparts, the gap is neither wide nor growing.

"Either everyone's the same credit, or these numbers are rigged," said James Bianco of Arbor Research. "And I don't believe that everyone's the same credit."

The British Bankers Association (BBA), which compiles and licenses Libor, stands by the numbers and says it regularly confirms their accuracy with market participants. Just because banks do not tend to show sudden jumps relative to their peers does not mean that the numbers are a poor proxy for actual borrowing costs, the trade group said.

Often interbank lending is "based on long-term relationships rather than a bank going into the marketplace and saying, 'What am I good for?' " said John Ewing, a director of the association. "Since 2008, a lot of these banks are dealing more bilaterally."

Setting aside the question of how reliable its components are, Libor itself remains well below the heights it reached after the Lehman Brothers failure. And its rise is still small in absolute terms — the three-month index is up only 29 basis points since February.

Still, "all things being equal, you'd clearly prefer that households had a Treasury-linked mortgage," said Mark Schweitzer, who has researched the effects of Libor's previous spikes as research director at the Federal Reserve Bank of Cleveland.

His research has concluded that a period of heightened bank credit risk would cost Ohio homeowners tens of millions of dollars a year, but he and other observers see little evidence that borrowers are being sufficiently compensated for that exposure through slightly lower rates.

Banks hedge their positions regardless of whether their exposure is Libor- or Treasury-based, and as much as anything, the preference may come down to familiarity and habit.

Though large institutions prefer Libor, "you get institutions below $2 billion, a lot of them understand the Treasury markets so much better than Libor," said Peter Taglia  , a vice president at First Horizon National Corp.'s FTN Financial Capital Assets Corp.

Even market participants who acknowledge Libor's value as a standardized instrument concede that, as a determinant of mortgage payments, it has its flaws.

"Hedging it is just a layup," said Rob Branthover of Mortgage Industry Advisory Corp.   in New York. "But the issue to me is that you now have an instrument that can be affected by foreign activity rather than what is going on domestically."

Certificate of deposit rates were seen as an acceptable proxy for many loan products during the 1980s, until Continental Illinois threw off the curve by offering sky-high rates shortly before its blowup. Treasuries did fine for a while, but the flight to safety during Long Term Capital Management's 1998 implosion had the perverse effect of reducing mortgage rates at a time when that made little sense. For lenders, Libor became king.

In the 1990s, "the world of mortgage origination shifted from Treasury indices to a Libor" index for adjustable rates, said Tom Millon  of Capital Markets Cooperative in Ponte Vedra Beach, Fla., which helps banks with hedging.

Securitization and the desire for a global standard played a big part in the switch, Millon said. "The global bond market is focused on Libor. … So when you originate an adjustable-rate mortgage, it seemed to make more sense," he said. "It's the most liquidly traded instrument in the global financial system."

Indeed, one advantage of Libor is that it is widely predicted — the futures are heavily traded on the Chicago Mercantile Exchange, effectively giving a market judgement on the composite number's trajectory.

Of course, it would not be difficult for a bank to see what the market expectation is and then adjust the numbers it reports to the British Bankers Association.

"I think Libor starts to blur the lines because it's such a well-known tradable," Millon said.

Credit-default swap prices suggest that such a feedback loop may exist. In Tuesday's survey for 12-month Libor, the 16 contributing banks reported that they could borrow at rates of 1.12% to 1.4%, with the vast majority of responses falling in a 15-basis-point range.

The swap market, meanwhile, suggests that buyers of credit protection on the institutions perceive sharply different credit risks, with insurance on some of the 16 banks costing more than twice as much as that on others, according to Markit Group Ltd.  

Ewing of the BBA dismissed the use of credit default swaps as a proxy for risk and cautioned against drawing conclusions from temporary discrepancies. "Everything we thought we knew about how pricing moved got completely shot out of the sky in 2008," he said. "Especially at the moment, the market's idiosyncratic."

A few years ago, in response to questions about Libor's reliability, the association created penalties for inaccurate reporting and a formal line to collect tips about misbehavior. Ewing said he has not recently heard that a particular institution is reporting lower numbers than the rates at which it has been borrowing, and "it is terrifyingly easy to get a hold of me."

He argued that Libor's popularity is evidence of its accuracy. "We started doing this in '86 because there was nothing better out there."

That may still be the case. Though ideas exist to make individual banks' Libor contributions more accurate — for example, asking the 16 banks to submit the rates at which they would lend to each other rather than the rates they could borrow at — it is not obvious that anyone would be thrilled to see this happen.

According to Barclays PLC's interest rate strategist, Mike Pond, the aggregate move in Libor appears to be roughly appropriate. Even if Libor were to understate the risk of some institutions, "it is showing credit concern" broadly, he said.

Similarly, even if Libor is a less-than-ideal baseline for small-business and mortgage lending rates in Peoria, it does not follow that a more accurate reflection of banks' stress would benefit borrowers or institutions. As Bianco  noted, it was in Wall Street's and the government's interest during the worst of the subprime crisis to keep banks' borrowing costs — both real and stated — as low as possible.

By intervening in the markets, "the Fed found a way to ram Libor down to 30 basis points," he said. "And we all thought it was a good idea because we were all afraid that, if Libor showed what we really thought, it would cause a million more defaults."



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