In my post What Happens If the Federal Reserve Drops Fed Funds to 0 Percent? I briefly discussed three money benchmark rates. I wrote that the Federal Reserve Board could lower the fed funds rate to 0% in the next month or two, and I mentioned how interest rates for commercial loans have historically been tied to the Wall Street Journal Prime Rate. I introduced a benchmark rate that many small business people might not understand, the London Interbank Offered Rate (LIBOR).
Today I want to provide a primer on these three rates and why the average business owner should have a working knowledge of them. This discussion is particularly relevant in light of a change that was made by the Small Business Administration (SBA) yesterday. Historically the SBA allowed lenders to either set fixed or variable interest rates on their flagship 7(a) and 504 loans, or they allowed banks to use the Wall Street Prime rate as a benchmark rate plus a maximum number of percents above the benchmark, depending on the bank’s perception of risk. SBA’s rules changed yesterday to allow banks, at their discretion, to use the LIBOR rate as their benchmark.
Since May 2007, Senators John Kerry and Chuck Schumer have been pushing for legislation to make SBA loans more reasonably priced and attractive for banks to make. Though no bills have passed Congress containing initiatives to help small business borrowers, the SBA was able to make the rate benchmark change at the urging of both houses of Congress.
Before I discuss what these SBA changes will mean to borrowers, I want to discuss in detail the three benchmarks.
Fed Funds – Fed Funds is the rate the U.S. Treasury charges member banks that borrow from the Federal Reserve Bank. It is currently 1.5% and may very well be reduced to 0% if the feds don’t start seeing banks loan money. In an ideal world, reducing this rate should encourage banks to loan money. During this current economic crisis, very few banks have increased their lending because this benchmark rate has dropped.
Wall Street Journal Prime Rate – This is a rate published by the Wall Street Journal. It is often called prime rate. It is the rate that the largest
Does that mean banks that use the LIBOR rate for variable rate loans will charge less? No, it just means they will add on a higher premium on top of their benchmark rate. Some lenders will have provisions that allow the rate to be based on the higher of the two rates.
So why is the SBA going to allow banks to use a primarily European monetary benchmark now? It turns out that many banks sell the SBA guaranteed portions of loans they originate on the secondary market. By allowing banks to use LIBOR to set the rate of their floating rate loans, the number of potential buyers of pools of SBA loans increases, thereby making it more attractive for banks to use the SBA program.