Good News and Scary News on LIBOR

Photo by flattop341

The latest news about LIBOR seems to offer both hope for relief and, I'm afraid, a portent of impending doom. On the one hand, short-term credit markets seem to be coming back, thanks to the more-or-less coordinated efforts of major governments. The overnight dollar rate (the rate participating banks think they can borrow at overnight from each other in London) eased this morning to 2.14% down from 2.18% yesterday morning, and down from over 5% just last Thursday. Even the intermediate-term 3-month dollar LIBOR, the key rate for most observers, slid 9 basis points to 4.55% today, down from from 4.82% last Friday. All of this seems to suggest that the recovery effort has begun to succeed, though more water will have to flow under the bridge before we can announce a real recovery.

On the other hand, the key 3-month LIBOR rate has a long way to go back to normalcy. A month ago, it was only 2.82%. As I mentioned a few days ago, adjustable rate mortgages (ARMs), student loans, and many other types of private loans with floating interest rates are pegged to LIBOR, and those that are resetting these days may nearly double their interest rates for the remainder of the reset period. This strikes me as a perverse and unwarranted windfall for the banks holding these loans. I know, I know, those who play with adjustable rates must take the downs with the ups, but market fundamentals pushing rates higher makes sense to me; irrational panic pushing rates up--as an indirect result of these very banks' shenanigans years ago in the mortgage market--is just wrong.

My question is this: how often to most ARMs reset? If they reset quarterly, one quarter of pain might be bearable, but the reset will be dramatic (from about 2.8% to over 4.5%). If they reset annually, as I gather most student loans do, an entire year of astonomically hiked interest could produce yet another round of distress and anguish for the folks on Main Street--and, yet again, a windfall for those on Wall Street. That being said, 3-month LIBOR one year ago was nearly 5.25%, so maybe this won't be a catastrophe after all.

Update: See this fascinating chart that shows (1) 3-month LIBOR was quite high (in the 4.5-5.5% range) 1, 2, and 3 years ago, but (2) it stopped running parallel to the benchmark federal funds rate earlier this year, unexpectedly darting upward to join the Prime Rate recently, as we've discussed earlier. This seems to suggest that we'll know when something approaching "normal" credit market conditions have returned when 3-month LIBOR returns to a few basis points above the fed funds rate (now 1.5%, so 3-month LIBOR of, say, 1.75%).

I'm more and more pleased that I have a fixed rate mortgage these days.