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Libor, the federal funds rate and the US prime rate: A primer

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What do the terms Libor, federal funds or the U.S. prime rate have to do with you? Well, if you hold any type of loan, such as a credit card or a mortgage, these interest rate benchmarks can make a big difference to your bottom line.

A primer on Libor, the federal funds rate and the U.S. prime rate

"It directly affects your pocketbook," says Rebel Cole, a professor of finance at DePaul University. For example, if you carry a balance on a variable rate credit card, the amount you have to pay each month is partially determined by the U.S. prime rate. That rate, in turn, is influenced by the federal funds rate, which the Federal Reserve sets during each of its Federal Open Market Committee meetings.

"These rates may seem obscure, but they have an actual impact," says Michael Tucker, a professor of finance at Fairfield University. Not just on you, but also your employer, your city and local businesses.

For example, a small business's ability to expand its operations may be determined, in part, by its ability to borrow what it needs to do so without paying high rates. A bank's ability to freely lend to that small business, in turn, is partially determined by its ability to borrow overnight funds at an affordable rate.

Nearly every U.S. consumer is affected in some way by the the federal funds rate, the U.S. prime rate or by Libor. However, exactly how they're affected -- and how these rates work -- is less than clear.

If you, too, are confused, here's a basic primer on what you need to know about three of the world's most important benchmark interest rates. 

U.S. prime rate

What it is
The U.S. prime rate is an interest rate benchmark based on the rates that banks charge their best customers. That usually means big businesses, says Fairfield University's Michael Tucker. "It's unlikely to be individuals, unless they're extremely wealthy."

How it affects you
Each bank sets its own prime rate, which is the bank's gold standard interest rate, against which all other interest rates based on the prime rate are set. Customers with the best ability to repay a big loan are charged interest based on the prime rate, or in rare cases, below the prime rate. All other customers, such as credit card holders, are charged the prime rate, plus additional percentage points, usually based on the customer's creditworthiness.

Libor-style rate-rigging:
Could it happen here?

It's unlikely, say experts.

"There's no evidence of the prime rate being manipulated if that's a concern," says Daniel Seiver, a professor of finance at San Diego State University. "The prime rate is an actual rate," he adds. "The thing about the Libor rate was, it was hypothetical."

In theory, a bank could say it is loaning money to its customers at a lower rate, making it look like the bank is more confident in the economy than it actually is, says Michael Tucker, a professor of finance at Fairfield University. "That could inspire business confidence," he says and so may be one motivation for misreporting a rate.

However, "there's been no indication that there's anything going on there," he says.

Monkeying with the prime rate would be much harder, says Tucker, because there's significantly more transparency in the U.S.

"We have more regulation than the Brits do," he adds.

So if you've got a variable rate credit card with a 9.99 percent APR, a fraction of that APR is determined by whatever the issuing bank's prime rate is at the time.

Typically, the U.S. prime rate is 3 percentage points above the federal funds rate. However, "there's no guaranteed relationship," says Daniel Seiver, a professor of finance at San Diego State University. A bank isn't obligated to tie its prime rate to the federal funds rate.  

How is it set?
The Wall Street Journal calculates and publishes the U.S. prime rate -- which is currently set at 3.25 percent -- by surveying 10 of the largest banks in the country and asking what rates are being charged to their best corporate customers. The paper publishes the U.S. prime rate daily, but it doesn't recalculate the rate until a certain percentage of banks say they've changed their rate. If at least 70 percent of the banks report that they have begun charging a different prime rate, then the Wall Street Journal recalculates a new base rate.

Generally, banks are slow to change their prime rate. If borrowing becomes costlier for a bank, then a bank will consider raising its prime rate so that lending remains profitable. "If it costs me more money to raise the money, then I have to charge you more for that loan," explains Bob Mark, founder and CEO of the consulting firm Black Diamond Risk. Mark used to play a key role in setting the prime rate for a Canadian bank and the system there is very similar, he says.

If a bank's lending costs go down, on the other hand, "they're likely to pass that savings on to you, the borrower," says DePaul University's Rebel Cole.

A bank also needs to independently consider what banks it competes with may do before the bank decides to announce a new prime rate to the market, says Mark. "The decision calls for applying a little game theory in terms of who goes first and do other people follow," he says. For example, "you don't want to be the first one to announce that you are raising the prime rate and you subsequently lose market share since no other bank ultimately follows." 

Generally, most banks tie their prime rate to the federal funds rate and wait for other banks to move before they make any changes. "All banks tend to change their prime rate around the same time and at the same level," says San Diego State University's Daniel Seiver.

Banks' tendency to move in lock-step with one another is partially why the U.S. prime rate has remained so stable. The U.S. federal funds rate hasn't moved since 2008 and neither has the U.S. prime rate. 

Federal funds rate

What it is
"The federal funds rate is the rate at which banks borrow from each other on an overnight basis," says DePaul University's Rebel Cole. It's the amount of interest banks pay in order to borrow fast cash.

Banks often borrow from one another overnight in order to keep the amount of money they have available at a certain, federally mandated level and make sure they have enough cash on hand for other needs. If a bank needs money quickly, the bank can get it by tapping another bank's balances, which are held at the Federal Reserve. "It's the way they can fund themselves in the very short term," says Cole.

How it affects you
Many variable rate loans in the U.S., such as credit cards, are based on the U.S. prime rate.  The prime rate, in turn, is typically 3 percentage points above the federal funds rate. So when the federal funds rate is changed, the annual percentage rates (APRs) of variable rate loans tend to immediately go up or down as well.

How it is set?
The actual federal funds rate is set by the open market as banks loan each other money from day to day.

The federal funds rate "target," on the other hand, is set by the Federal Open Market Committee (FOMC), which is headed by Federal Reserve Chairman Ben Bernanke. Generally, when commentators refer to the federal funds rate, they're usually referring to the target rate set by the Fed, rather than to the actual federal funds rate.

The FOMC meets every few months and decides whether to raise the federal funds rate target, lower it or keep it as is.

The target rate is used as a tool to help control the nation's money supply and promote employment. For example, if inflation begins to run above the Federal Reserve's target rate, the Fed may choose to raise the federal funds rate target. By doing so, the Fed is restricting the amount of money that's available to banks, making it more likely that they'll raise interest rates on commercial and consumer loans. That, in turn, should help control the prices of goods and services by dampening commercial activity.    

Meanwhile, if the U.S. economy is sputtering and unemployment is high, the Fed may choose to lower the federal funds rate target in order to help bring borrowing costs down and encourage businesses and consumers to spend.

That's what the Federal Reserve did in 2008 when the economy headed into a tailspin. As banks clamped down on lending, the Federal Reserve pushed the federal funds rate target down to rock-bottom -- between 0 percent and 0.25 percent. The target rate hasn't moved since, and FOMC members say they're unlikely to move it until at least late 2014.

Libor

What it is
"That's the bank rate that banks loan money to each other," says Fairfield University's Tucker. Unlike the federal funds rate, which only applies to U.S. banks, the London Interbank Offered Rate (or Libor) is a London-based international interest rate benchmark used around the globe.

Often referred to as the world's most important short-term interest rate, Libor is used as a benchmark for a wide variety of loans in the U.S. and abroad.  "Fewer and fewer loans are tied to the prime rate," says Cole. "More and more are tied to Libor or to treasuries."   

How it affects you
Most U.S. credit cards are based on the prime rate. However, a large number of other consumer loans, such as mortgages, tend to be based on Libor. "A lot of American households could have mortgage loans that are variable and they are tied to Libor," says San Diego State University's Seiver. "I have a mortgage myself that adjusts every year. If you have an adjustable rate mortgage, then [Libor] could very well determine your mortgage."

In fact, according to a 2009 study by the Federal Reserve Bank of Cleveland, nearly 60 percent of prime U.S. mortgages in the state of Ohio were tied to Libor in 2008 and nearly all subprime mortgages were tied to Libor.

Other consumer loans tied to Libor may include private student loans and auto loans. To check which interest rate your loan is pegged to, look through your loan documents and check for wording that mentions either the London Interbank Offered Rate or the prime rate. If you find that you have a loan that is based on Libor, also check what type of Libor rate it is. Commentators often refer to Libor as just one rate. However, there are multiple types of Libor rates, including a 1-month Libor rate, a 3-month Libor rate, a 6-month Libor rate and a 1-year Libor rate.

How is it set?
A sample of 18 banks, including Barclays, Chase, Citi, HSBC and Bank of America, report to the British Bankers' Association how much interest they expect to be charged by other banks for a short-term loan. Banks' interest rate estimates aren't required to be based on actual transactions. However, the banks are expected to give their best guesses.

The news and information service Thomson Reuters then takes that information, throws out the four largest reported rates and the four smallest reported rates, which it says are outliers, and averages the 10 rates in the middle.  It then publishes the new information each morning on behalf of the British Bankers' Association. 

Not all banks have been following the rules, however. As of press time, at least one major bank, Barclays, admitted to falsely reporting a different rate than the bank expected to be charged and a number of other banks are under investigation for doing the same. Bankers' reasons for manipulating the Libor rate varied, according to numerous press reports. In some cases, banks directly profited from the manipulated rates. In other cases, rates were manipulated in order to make a bank look healthier than it actually was.

The revelation that rates were rigged sent shock waves through the financial system as regulators considered legal action and consumers came to terms with the fact that the interest rates on their loans may have been based on made-up figures.

"The major problem here is that people believed that the rates that were being reported were the actual lending rates," says Fairfield University's Tucker. "If it turns out there was collusion and these were not the rates, then the whole system is suspect."

The impact on consumers is relatively small, say experts. "The cheating that's gone on is so small that really it is not material to a borrower on their loan," says DePaul University's Cole. However, those tiny changes "can be hugely profitable to a bank that has trades that are tied to the Libor rate," he says.   

The small differences in rates can also profoundly affect other big borrowers, such as U.S. cities, which borrow huge amounts and so are more vulnerable to small changes.  

As of press time, regulators at the Bank of England have announced plans to reform the Libor-setting process and are currently taking steps to make it less susceptible to manipulation.

The bottom line: These rates matter. Benchmark interest rates, such as the prime rate, may be slow to move. However, when they do, they can make a big difference to how much you'll pay on the life of your loan.

So if you've got a variable rate loan, the best thing you can do for your wallet is to pay close attention to the rates your loans are based on, say experts. Be prepared for sudden rate increases and know before you sign up for a brand-new loan that your expected payments could change significantly in the future.    

See related: As expected, Fed keeps rates at rock bottom.

Published: September 5, 2012


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