LIBOR On Shaky Ground

This post first appeared on Minyanville.

One upshot of the ongoing credit market turmoil has been a sharp increase in new acronyms added to the financial lexicon. The London Interbank Offer Rate, or LIBOR, is one such noteworthy addition.

LIBOR measures the rate at which banks lend to one another. When banks become skittish and seek higher return for additional risk, LIBOR goes up. Conversely, LIBOR moves downward when fear abates and lending loosens up. Depending on whom you ask, the rate is tied to $150-$350 trillion in financial assets.

In recent weeks, the integrity of the data collected to determine LIBOR has come into question. Banks were accused of misrepresenting their borrowing costs to contain fears the financial markets were unraveling. As the demise of Bear Stearns (BSC) proved, those concerns were warranted.

Each morning, the British Bankers' Association, or BBA, surveys 16 banks -- including Bank of America (BAC), JPMorgan (JPM) and HSBC (HBC) -- about their borrowing costs. It tabulates the results by tossing out the four highest and lowest values and taking the average of the remaining data points.

After weeks of deliberation over the alleged misrepresentations, the BBA announced Friday it wouldn't change its methodology. Bloomberg reports the BBA said it would "increase oversight" and called the issue "very serious."

That LIBOR's integrity has come under scrutiny is somewhat worrying. That an unregulated body responsible for the maintenance of the most widely used benchmark in finance can't be bothered to safeguard its practices is cause for outright alarm.

One expert told Bloomberg, "LIBOR is an inherently flawed index. [It's] an unresolved problem as it's not based on actual trades and actual borrowing costs but on people's guesses. Either it will die or it will change."

But the likelihood of LIBOR going away is slim. According to The Wall Street Journal,
in addition to the trillions of dollars in complex derivative investments based on the benchmark, $900 billion in subprime mortgages are tied to LIBOR.

If the myriad of failed mortgage bailouts has proved anything, it's the inability of the mortgage servicing industry to coordinate its way out of a paper bag. Servicers have the thankless job of collecting mortgage payments and chasing down borrowers if they don't send in checks.

It was fantasy to assume the industry could have affected such broad change with any degree of success. Even if regulators had concluded LIBOR's flaws were serious enough to warrant a switch to another benchmark, little could have been done. Any attempt to alter such a vast quantify of mortgages would be a disaster.

The financial markets are already crippled by mounting losses that don't appear to be abating. They now must creep along on a shaky foundation, one which fewer and fewer participants trust to weather even a mild storm. Landfall, indeed, will be a doozy.