Q&A: What is Libor, and how does it affect you?

WASHINGTON — It goes by a clumsy acronym, and its inner workings may be difficult to understand, but a key interest rate set in London every business day is having a dramatic impact on the U.S. and global economies as the credit crisis has intensified.

Here are some questions and answers to help make sense how this interest rate, known as Libor, may affect your household:

Q: What is Libor?

A: Libor, an acronym for the London Interbank Offered Rate, is the interest rate at which large international banks are willing to lend each other money on a short-term basis. It's calculated every business day in 10 currencies and 15 terms, ranging from overnight to one year.

Q:How big is its influence?

A: Rates on about $10 trillion in corporate loans, mortgages and student loans worldwide are pegged to Libor, usually with a markup of several percentage points, according to University of Edinburgh professor Donald MacKenzie. The total amount of financial contracts tied to Libor, particularly interest-rate swaps, exceeds $300 trillion, or $45,000 for every person in the world.

The rate ended up being calculated in London after President Lyndon Johnson tried to stop dollars from moving overseas in the 1960s. In response, a so-called "Eurodollar" market developed in dollar-denominated deposits held by foreign banks.

The calculation of Libor is so important to the world's financial system that its coordinators have set up dedicated backup phone lines so the number can still be figured out if there's a terrorist attack, MacKenzie wrote in a recent paper in the London Review of Books.

Q: How does it get set?

A: Every business day, more than a dozen banks report to the British Bankers Association (BBA) their estimates of the rates at which they are able to borrow money from other banks. After discarding the highest and lowest rates reported, BBA staffers average the rest and report the figures daily after 11 a.m. London time. This system, in place since the mid-1980s, has generally worked well, MacKenzie said in an interview. Without a globally accepted benchmark for interest rates there would be "chaos and confusion," he said.

Q: OK, so what's the problem?

A: In more normal times, Libor rates usually track about half a percentage point above the yields on U.S. government debt with comparable maturities. But that gap has widened considerably in recent weeks, increasing borrowing costs for millions. On Friday, the six-month Libor rate was 2.3 percentage points above comparable Treasury bills. A year ago, the difference was 1.2 percentage points.

Q: Why is that happening?

A: With major institutions such as Washington Mutual and Lehman Brothers failing, banks are extremely wary about lending money to each other because they are worried about who will be the next to fail. "The level of trust has... just evaporated," said John Silvia, chief economist with Wachovia.

Q: So how does it affect my life?

A: More than half of U.S. adjustable rate home loans are tied to Libor, so a recent increase in this benchmark rate mean monthly mortgage payments will rise for affected homeowners if the rise is sustained. A typical adjustable rate home loan will adjust based on the six-month Libor, plus 2 to 3 percentage points. Plus, many home equity lines of credit, small business loans and student loans also use Libor as an index. Student loans, for example, can be set based on the three-month Libor rate plus, say, 4 percentage points or the one-month Libor rate, plus 9 percentage points.

Q: Why are so many U.S. home loans tied to these rates?

A: Adjustable-rate mortgages used to be based on the yields of short-term government debt. But as international money flowed into the U.S. mortgage market this decade, investors in mortgage debt wanted to use a rate "that was a little more indicative of their cost of doing business in global markets," said Keith Gumbinger, a senior vice president with financial publisher HSH Associates.

Q: How does it impact the economy?

A: Because Libor's elevated state has pushed up rates on adjustable mortgages as well as rates on many commercial loans, that has blunted the effectiveness of the recent interest-rate cuts enacted by Federal Reserve policymakers in an effort to stimulate the economy. It also means consumers, who account for more than two-thirds of total U.S. economic activity, can find their access to credit restricted. "Consumers are going to be retrenching and trying to cut down their spending," said BNP Paribas economist Anna Piretti.

Q: What does it mean for borrowers in danger of losing their homes to foreclosure?

A: Borrowers with high-rate adjustable mortgages are already defaulting in huge numbers. While rates for Libor are rising, they are still about 1.24 percentage points lower than a year ago.

Rising interest rates are not good for borrowers facing foreclosure, said Jay Brinkmann, chief economist with the Washington-based Mortgage Bankers Association. But, he added, "it's not clear that the magnitude is going to be that great unless it goes up even more."