by Tanta on 9/26/2007 08:27:00 AM

Well, you know what's in your cornflakes--I hope. Do you know what's in your ARM index? According to the Financial Times, the London Interbank Offered Rate may well mean Selected London Inter-Marginal Bank Offered Rate:

“The Libor rates are a bit of a fiction. The number on the screen doesn’t always match what we see now,” complains the treasurer of one of the largest City banks.

Such criticism is, unsurprisingly, rebuffed by those who compile the index each day. However, it highlights two other trends that have emerged in the money markets in recent weeks.

One of these is a growing divergence in the rates that different banks have been quoting to borrow and lend money between themselves.

For although the banks used to move in a pack, quoting rates that were almost identical, this pattern broke down a couple of months ago – and by the middle of this month the gap between these quotes had sometimes risen to almost 10 basis points for three month sterling funds.

Moreover, this pattern is not confined to the dollar market alone: in the yen, euro and sterling markets a similar dispersion has emerged. However, the second, more pernicious trend is that as banks have hoarded liquidity this summer, some have been refusing to conduct trades at all at the official, “posted” rates, even when these rates have been displayed on Reuters.

“The screen will say one thing but people are actually quoting a different level, if they are quoting at all,” says one senior banker.

Some observers think this is just a short-term reaction to the current crisis. However, it may also reflect a longer-term shift. This is because one key, albeit largely unnoticed, feature of the banking world in recent years is that many large banks have reduced their reliance on the interbank market by tapping cash-rich companies and pensions funds for finance instead.

The recent crisis appears to have accelerated this trend. In particular, it appears that some large banks have in effect been abandoning the interbank sector in recent weeks, turning to corporate or pension clients for funding by using innovative repurchase agreements.

This trend is bad news for smaller institutions, such as British mortgage lenders, because these, unlike large banks, generally do not have any alternative ways of raising funds outside the interbank world.

Almost all subprime ARMs, the vast majority of Alt-A ARMs, and a significant chunk of prime ARMs are indexed to 6- or 12-month (dollar-denominated) LIBOR in the U.S. (I'm still looking for a source of exact figures.) One of the ways LIBOR was "sold" to consumers who were used to old-fashioned indices like Constant Maturity Treasury (CMT) or Cost of Funds (COFI) was that it "lagged" these U.S.-centric indices on the upside, implying that LIBOR ARM rates would not rise as quickly. That was mostly nonsense then, and it may be pretty painful nonsense now if the interbank borrowing practices on which LIBOR is based shift such that it becomes a "penalty rate" for bank borrowing.

Prediction: If we "innovate" back to Treasury-based ARM indices (by pulling those dusty old CMT notes out of the drawer), it will be sold to you all on the basis that CMT is a "lagging" index.