Scientific experiments use control factors as reference points from which all other measurements are taken. In the financial world, one of the most important of such constants is known as LIBOR, the London Interbank Offered Rate.

LIBOR measures the rate at which banks lend to one another. When banks become skittish and seek higher return for additional risk, LIBOR goes up. Conversely, LIBOR moves downward when fear abates and lending loosens up.

The spread (or difference) between LIBOR and virtually risk-free U.S. Treasuries measures the premium banks' demand to lend to other banks. In the past nine months, the spread between LIBOR and three-month Treasury yields has taken off.


Source: The Wall Street Journal

While many have argued the reasons and implications for LIBOR's wild swings, few have questioned the integrity of the data itself. Until now.

The Wall Street Journal reported yesterday that the group that oversees LIBOR, the British Bankers Association, or BBA, is starting to question the validity of the information it collects to determine each day's rate.

Each day, 16 of the world's largest banks, including Bank of America (BAC), JP Morgan (JPM) and HSBC (HBC), tell Reuters what it costs to borrow a "reasonable amount" in a designated currency. Reuters tosses out the highest and lowest quotes to negate the effect of outliers and arrives at an average bank-to-bank lending rate. The data is then disseminated around the world's financial markets.

LIBOR is used to set the terms of corporate debt, home loans, mortgage-backed securities and over $500 trillion in derivative contracts. It's the standard by which nearly all fixed income securities are measured. For example, subprime mortgages may cost a borrower 6.00% more than the LIBOR rate, whereas a well-capitalized corporation may pay only 0.50% above LIBOR on its highest rated debt.

According to The Journal's report, the BBA isn't sure its reporting banks are telling the truth. No specific allegations have been made, but some traders are concerned banks may be colluding or otherwise spreading misinformation to give the impression market conditions are better than they really are.

The implications -- if true -- are significant.

By some estimates, LIBOR may be underestimating the true cost of bank-to-bank borrowing by as much as 0.30%, a meaningful figure considering Tuesday's three-month Libor rate sat at just 2.72%.

The real losses stemming from a systemic adjustment to LIBOR would be trivial compared to the psychological effect such a correction would have on financial markets.

There's a growing belief the wider implications of the credit crunch, although extensive, can be quantified and priced into an individual stock or bond. We're now being told financial companies' share prices have so much bad news baked in, they can't conceivably go any lower.

This talk sounds comforting on the brink of recession and, according to some, the biggest financial crisis since the Great Depression. And while in the near term such a thesis may be true, any such assumption is purely speculation.

If LIBOR -- heretofore as reliable an index as the rising sun -- can't be accurately determined, the ability to reasonably value any asset is called into question. From the very top (LIBOR), to the very bottom (residential real estate), illiquidity and a lack of trust are rendering any concept of rational markets invalid.

Any analyst who proclaims financial companies are cheap, or have strong balance sheets, is at best taking a stab. If an index so universally accepted as LIBOR is called into question, what does that say about what the $70 billion in Level III assets sitting on Goldman Sachs' (GS)? Anyone proclaiming to know their actual value is simply guessing.

The concern over LIBOR may be nothing, or it may be the sort of issue that slowly turns from rumor into reality, not unlike recent events surrounding the collapse of Bear Stearns (BSC). But the fact that its integrity is even being called into question could mean banks are hiding something they really, really don't want anyone to know about.