LIBOR introduces interest rate floor
The Federal Reserve building is seen January 22, 2008 in Washington, DC.
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KAI RYSSDAL: It's all rates all the time on the program today. Now that we've covered the federal funds rate, let me trot out another one. It's a beast called the "London Inter Bank Offering Rate," LIBOR for those in the know. It's the rate at which banks lend to each other, but not just banks in London. Institutions all over the world use it, usually to help set interest rates on big corporate loans. That's fine when rates are heading up, but when the Federal Funds rate falls, LIBOR falls too, which means banks could lose money if they're not careful. The last thing the economy needs now is more loans gone bad, so smart lenders are building in some insurance.
From New York, Ashley Milne Tyte reports.
ASHLEY MILNE-TYTE: When companies apply to a big bank for a large loan, the bank goes out and recruits smaller investors to share the burden. The bank and the investors set the interest rate, a certain percentage on top of the LIBOR rate. That way when LIBOR rises, the interest rate on the loan floats up. Ed Ribaudo is managing director of GE Capital Markets. He says now that interest rates are falling, investors are watching the return on their investments get squeezed.
ED RIBAUDO: So they've introduced the concept of a floor to prevent it further eroding the return that they're guaranteeing to their underlying investor.
The LIBOR floor guarantees investors will be paid a certain amount of interest now matter how much the Federal Reserve cuts rates. Mike Hatley is president of Westgate Horizons Advisors. He says investors are worried about the weakening economy, and the possibility that more loans will default.
MIKE HATLEY: And so with that sort of a backdrop, the arrangers of loans need to look for ways to make their loans more attractive to investors, and putting a LIBOR floor is one way to make the loan more attractive.
That helps lenders, but it flies in the face of what the Fed is trying to do. Ben Bernanke is cutting rates because he wants to make it easier for companies to borrow, but if the company gets a loan with a built-in LIBOR floor, it could find itself paying a high rate of interest, no matter how many cuts the Fed makes. Steve Miller is a director at Standard and Poor's. He says so far only a few companies have been affected by this, and the ripple effects shouldn't spread far.
STEVE MILLER: It wouldn't be some, you know, wide-ranging effect across the economy, but it does make it more expensive for borrowers that are facing liquidity challenges today to get amenable financing terms.
Miller says the riskier the company is, the more likely their investors are to insist on a LIBOR floor, and a guaranteed payback rate.
In New York, I'm Ashley Milne-Tyte for Marketplace.