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Ordinary investors work hard to understand the basics of investing. For many of them, trying to get a handle on the myriad acronyms and frequent use of jargon by professional investors is more trouble than it's worth.
As a result, it would be easy for you to dismiss the recent scandal involving allegations that Barclays took steps to rig what's known as the LIBOR as something too esoteric to care about. But ignoring the scandal would leave you with the mistaken impression that LIBOR isn't important for average people. As millions of people are about to find out, nothing could be further from the truth.
LIBOR and you
LIBOR stands for "London Interbank Offered Rate" and actually refers to more than 150 different rates. You can find LIBOR figures for a variety of maturities between a single day and a full year in each of 10 different currencies, including the U.S. dollar, the British pound, the euro, and the Japanese yen.
The calculation of LIBOR is simple. Every day just before 11 a.m. London time, Thomson Reuters (NYSE: TRI ) , which is the designated calculation agent for the benchmarks, receives information from the LIBOR contributor banks asking them at what rate they'd be able to borrow funds from other banks. It then calculates the appropriate LIBOR by looking at all the rates submitted, tossing out the top quarter and the bottom quarter, and then taking the average of the remaining figures. So if 12 banks submitted figures for a particular rate, the LIBOR would be the average of the middle six after eliminating the top three and bottom three.
LIBOR has a direct impact on many people. Those who have adjustable-rate mortgages often have their rates tied to an appropriate LIBOR benchmark, with mortgage rate resets based on changes in the LIBOR over time. Add in credit cards, car loans, and other credit, and the British Bankers' Association estimates that roughly $10 trillion in loans base their rates on LIBOR.
Looking past the obvious
As much as LIBOR influences ordinary people's lives, the much larger impact comes from the financial markets. LIBOR figures are used for an estimated $350 trillion in notional value of credit-default and interest-rate swaps. For instance, both Annaly Capital (NYSE: NLY ) and American Capital Agency (Nasdaq: AGNC ) hedge their extensive borrowings using swaps tied to LIBOR. All told, more than $800 trillion in loans, securities, and notional derivative contracts has links to LIBOR. Those securities include interest-paying investments which pension funds and other institutional investors own, making for an indirect impact on tens of millions of workers and retirees.
Because of the pervasive use of LIBOR, the benchmarks take on huge importance not only in the interest rate market, but throughout the financial world. During the financial crisis four years ago, when LIBOR soared well above the prevailing Fed funds rate set by the Federal Reserve, analysts concluded that the credit markets had come to a screeching halt with banks afraid to lend to each other. Similarly, during flights to safety that push rates on Treasury bills to artificially low levels, LIBOR serves as another gauge that can provide a different perspective on the credit markets.
With so much money involved, it's understood that the rate-fixing scandal is a big deal. Barclays is getting the lion's share of the attention, especially since CEO Bob Diamond resigned and the bank was fined $450 million by regulators in the U.S. and the U.K. for deliberately underreporting its rates for purposes of calculating LIBOR.
But more than a dozen other banks are under investigation to see whether they had a role in the scheme as well. Even though the rates are generated in London, Citigroup (NYSE: C ) and JPMorgan have said that regulators are looking into their overseas practices, while reports include Bank of America (NYSE: BAC ) in the mix as well.
The future of LIBOR
Unfortunately, the methodology for calculating LIBOR inherently relies on cooperation from the banks involved in the daily survey. Although changes in that methodology have made the calculation less susceptible to manipulation and increased accountability to some extent, LIBOR's accuracy nevertheless depends on the integrity of the banks that participate. As we've seen countless times in recent years, counting on banks to do the right thing is often a risky proposition.
Whether LIBOR fundamentally changes depends on what the derivatives markets demand. Whatever happens, though, will have lasting repercussions on the entire financial industry.
LIBOR will play a role in the political debate going forward as well, and that could have a big impact on the entire market. Learn more about the potential opportunities and threats that will follow the 2012 elections by reading the Fool's latest analysis on strategies to protect and increase your wealth -- regardless of who wins.