What Was Libor?

Gill Allen | Bloomberg | Getty Images

Pedestrians pass 30 South Colonnade, centre, where the London interbank offered rate, or Libor, was set daily.

Matt Levine at Dealbreaker points out something that I had never quite realized: A lot of smart people believed that Libor was the risk-free rate of interest.

The Libor scandal has always puzzled me in part because I grew up believing this:

There is a small chance that an AA-rated financial institution will default on a LIBOR loan. However, they are close to risk-free. Derivatives traders regard LIBOR rates as a better indication of the "true" risk-free rate than Treasury rates, because a number of tax and regulatory issues cause Treasury rates to be artificially low. To be consistent with the normal practice in derivative markets, the term "risk-free rate" in this book should be interpreted as the LIBOR rate.

That quote is from 2006, and looks sort of adorably naive now—banks are close to risk-free! and AA-rated for that matter!—but the guy, as the saying goes, literally wrote the book on derivatives. In financial markets, pre-crisis, Libor (and Euribor) was less "the rate at which banks borrow from each other" (or "the rate at which banks don't borrow from each other") and more "the risk-free rate for discounting stuff."

Plenty of people – in derivative markets, but also lots of people who borrowed using Libor—thought of Libor that way: it was just "the interest rate," intended to be risk-free. Making it relatively insensitive to big-bank credit would be, on this theory, a feature, not a bug.

In other words, if you think that Libor is supposed to be just a measure of the risk-free rate of interest, then having people manipulate it during a crisis so that it did not accurately reflect the market view of risk in bank lending is not a big deal. The manipulators were helping Libor stay risk-free.

What strikes me as so odd about this view is that I never, ever encountered it in the entire five years or so I spent arranging gargantuan Libor loans.

I was a corporate lawyer at a couple of the biggest law firms in the United States and my specialty was leveraged loans. Every single loan I lawyered was a Libor loan. No one ever communicated to me their view that Libor was meant to be risk free.

Our credit documentation made it very clear that we used Libor because it was usually pretty good at reflecting the cost of funding for banks. Since these loans were usually syndicated and held by a broad group of banks, it was simpler to use Libor than to calculate the funding costs for each bank separately. And, usually, the market didn't charge different banks very different rates anyway.

But we had a sneaky clause in our credit agreements that made it very clear that what borrowers were going to pay was the cost of funding or Libor, whichever was higher. That clause said that if for some reason some of the lender's cost of funding was significantly higher than Libor, the borrower was going to pay that higher cost of funding.

That's right. If a bank's cost of funding went up idiosyncratically, the borrower got penalized. If a bank was suddenly considered a big credit risk, it's borrowers paid the premium.

This, to me, demonstrated that we were using Libor because it usually reflected the cost of funding. But, apparently, folks in the derivatives world had a very different view of things.

Follow me on Twitter @Carney