Yesterday, the Federal Reserve cut short-term interest rates by a quarter of a percentage point to 4.25% -- the central bank's third rate cut since mid-September -- to help ease the credit crunch and reduce the economy's chances of falling into a recession. The moves have helped some borrowers who have seen interest rates on their credit cards and home-equity lines of credit fall. Interest rates on many fixed-rate mortgages also have dropped amid a decline in Treasury yields as investors sought out safe investments.
But rates remain stubbornly high on other loans, including student debt and many adjustable-rate loans made to the same type of subprime borrowers whose troubles are now reverberating throughout the global financial system. These rates remain high because many of these loans are tied to the London interbank offered rate, or Libor, and not to more conventional interest-rate benchmarks such as Treasurys or banks' prime rate.
Libor, which is an interest rate banks charge on loans to each other, normally tracks the federal-funds rate closely. But continuing worries over the credit crisis have kept Libor unusually high -- partly because banks are reluctant to lend to one another -- even as other short-term interest rates have fallen in recent months. The U.S. dollar three-month Libor yesterday was 5.11%, down from 5.36% in late June. Over the same period, three-month Treasury bill yields have fallen much more steeply, to 2.95% from 4.8%. "The Libor spread is screaming that there is a big, big stress point in the banking system," says James Bianco, president of Bianco Research LLC, a market-research firm in Chicago.
Borrowers may need to read the fine print of their loan agreement or contact their lender to know what benchmark their loan is tied to. The biggest impact is likely to be felt among borrowers with ARMs that are about to reset. "If you have a Libor-indexed ARM and you're facing a reset, that's going to be very disadvantageous because of the divergence between the Libor and Treasury yields," says Greg McBride, a senior financial analyst at Bankrate.com.
For example, consumers with an ARM whose annual reset rate is linked to one-year Libor are likely to see their interest rate jump to 6.75% or more. By contrast, a similar loan that's linked to one-year Treasurys is likely to reset to a rate that's about 5.75%, he says.
Libor is frequently used to set rates for ARMs made to subprime borrowers -- mainly people with scuffed credit -- as well as many ARMs that fall into the "jumbo loan" category, which currently refers to most mortgages for $417,000 or more, says Keith Gumbinger, vice president of mortgage-tracker HSH Associates. Also, roughly half of non-subprime ARMs that were originated in recent years are tied to Libor, he estimates.
The higher Libor rates complicate the Fed's efforts to assist troubled borrowers and prevent problems related to the housing crisis from spreading further through the economy.
"The more problems we have in the subprime-mortgage market, the more the likelihood of defaults and foreclosures," says Ray Stone of Stone & McCarthy Research Associates. The federal government has outlined a "rate freeze" program that calls on mortgage servicers to modify certain subprime-mortgage loans to avoid foreclosure.
A recent report from the Federal Reserve Bank of New York shows that the six-month Libor rate will determine the reset rates for an estimated 99% of subprime ARMs and 38% of Alt-A ARMs in the U.S. that have been securitized. A further 1% of subprime ARMs and 22% of Alt-A ARMs will reset based on the one-year Libor rate. Alt-A is a category between prime and subprime that often involves borrowers who don't fully document their income or assets.
In recent years, lenders began pegging a greater percentage of loans to Libor as more of this debt was securitized and sold to investors around the world, analysts say. Since Libor is a global interest-rate benchmark, investors have an easier time hedging their interest-rate risk because their investments are pegged to a common index, says Bankrate.com's Mr. McBride.
Another factor: Since the U.S. Treasury Department stopped selling one-year Treasurys in 2001, more lenders started tying their hybrid adjustable-rate mortgages to Libor because they believed the Libor index more accurately reflected their funding costs over time than other benchmarks, says Lou Barnes, partner at Boulder West Financial Services, a Colorado mortgage bank.
Other Libor-based loans include certain types of student loans. About half of student lenders peg their private, variable-rate student loans to Libor. The best rates on private student loans are typically prime minus one percentage point or Libor plus 1.8 percentage point, says Mark Kantrowitz, publisher of FinAid.org, a financial-aid Web site. Normally, those rates are very similar, but right now, Libor-based rates are a little bit higher, he says.
That doesn't mean borrowers with Libor-linked loans should jump to other types of loans. Private student loans pegged to Libor, for example, have historically tended to charge a slightly lower rate than loans tied to prime over the life of the loan, says Mr. Kantrowitz.
Homeowners, on the other hand, may be better off in Treasury-linked ARMs over Libor-linked products, if both are available on comparable mortgages. Historically, in times of credit crisis, Libor rates have tended to spike, says Mr. Barnes, the mortgage banker. But Treasury yields at such times often are driven down by investors seeking safe investments, he says.
One bright spot for savers: Higher Libor rates have helped sustain healthy returns in money-market mutual funds. These funds' holdings of Libor-linked debt have helped to offset declining yields on other investments. An estimated 20% to 25% of money-market assets are in floating-rate debt, much of which is linked to Libor, says Peter Crane of Crane Data LLC. That has helped to keep average yields on money-market mutual funds, currently about 4.57%, about a quarter of a percentage point higher than they would normally be in the current interest-rate environment.
The Fed rate cuts have helped borrowers of some other types of loans, especially those tied to banks' prime rate. Average rates on home-equity lines of credit have dropped to 7.60% from 8.25% in early September, while variable-rate credit cards are now charging 13.46% on average, down from 13.97%, according to Bankrate.com.
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