Chandler Bond Market Review

What the LIBOR Scandal Means for Investors

Commonly known as LIBOR, the London Interbank Offered Rate is considered one of the most important interest rates in finance. It serves as a reference rate for trillions of dollars of derivatives and financial contracts, and also as a benchmark for debt that most people are familiar with:  adjustable rate mortgages, student loans, small business and corporate loans.

How LIBOR is determined

LIBOR is the interest rate at which top-tier banks in London offer to lend unsecured funds among themselves on a short term basis. LIBOR rates are set each business day through a process overseen by the British Bankers’ Association. Between seven and 18 large banks are asked what interest rate they would have to pay to borrow money for fifteen different time periods, ranging from one day to one year. The responses are collected by the firm Thomson Reuters which makes some adjustments for outliers, calculates the averages, and creates the LIBOR quotes.

Historically, the banks in the LIBOR market have been among the strongest credits in the world.  This type of lending has been viewed as extremely low risk, and, as a result, LIBOR has been among the lowest interest rates available in the market.

LIBOR is unique in that it is not determined by supply and demand. Neither is it set by any government. Instead, it is based on an honor system whereby banks are assumed to report accurately the interest rates they would have to pay to borrow.

The scandal

When the accuracy of the data the banks report is questioned, the integrity of the markets is threatened. In the recent LIBOR scandal, two general types of manipulation came to light.

In the first place, certain banks moved LIBOR levels (up or down) to lower their cost of borrowing, and, more significantly, to benefit their investment positions. Lower LIBOR rates resulted in higher valuations of the banks’ fixed income investments.

The second scheme occurred during the financial crisis.  Certain banks underreported LIBOR to appear more creditworthy. Like consumers and investors, banks were reluctant to lend to each other during the crisis as markets seized. By posting lower LIBOR reports, some banks gave the appearance of being financially stronger. Given that there was not much direct lending or “funding” being done during this time, undermined the validity of the published LIBOR rates. Taking this line of reasoning a step further, systemic underreporting of LIBOR during the crisis served to ease the sense of panic.  Some critics are questioning whether there was some complicity on the part of the regulators.

Barclays Capital and others

In July of this year, Barclays Capital reached a settlement with U.K. and U.S. regulators and paid approximately $450 million, admitting that it lied in its LIBOR submissions about its cost of borrowings.

According to the settlement, between 2005 and 2008, Barclays’ traders repeatedly plotted with bankers charged with its LIBOR reporting, to tailor the bank’s reports to benefit their trading positions.  Even more damaging, Barclays staffers also conspired with counterparts from other banks to manipulate rates.

Demonstrating the second form of LIBOR fraud, during the height of the financial crisis, between late 2007 and early 2009, Barclays made artificially low LIBOR submissions, fearful that reports of high borrowing costs would be punished by the market as investors questioned its financial health.

Deutsche Bank, the Royal Bank of Scotland, Credit Suisse, Citigroup, and JPMorgan Chase have acknowledged they are being investigated by regulators in the LIBOR scandal.

Why it matters

Some argue that any damage to consumers has not been meaningful. After all, lower LIBOR rates mean smaller payments for mortgages, car and student loans, and other forms of debt. Lower rates continue to bolster the debt of the United States and Germany, underpinning global economies.

However, the fraudulent LIBOR submissions made by banks undermine the foundation of the markets.  When markets are transparent, the movement in prices provides a signaling mechanism for investors; the LIBOR scandal broke this mechanism for investors. For all the gains made by banks on their financial contracts or derivatives, there were counterparties on the other side – whether factories, farmers, or governments using derivatives to hedge a risk or pension fund and money market investors holding LIBOR based products.

For investors

With the fraudulent LIBOR submissions, pensions, mutual funds and other investors with investments in LIBOR-based securities earned less interest. Since the controversy is not yet resolved, it is too early to estimate the interest income lost by investors in short, liquid investments.

The negative impact on investors does not stop there. Many bank stocks and debt continue to trade at discounts to the general market, negatively affecting anyone who owns bank issued securities, both equities and fixed income.

Conclusion

The scope of the financial arrangements affected by LIBOR makes the proportions of this scandal staggering. The full impact on investors and borrowers is yet to be realized as the scandal works its way through regulatory, criminal and civil jurisdictions. Likely outcomes include reform of the procedure for calculating LIBOR, with a shift to actual borrowing or funding costs reported automatically, rather than costs reported by interested parties,  and tighter regulation and oversight of the entire process, along with increased transparency. Regulatory bodies have started imposing punitive fines and investors are considering actions for remedial relief.

– Sofia Anastopoulos, CFA

VP, Client Service

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

This entry was posted in Articles. Bookmark the permalink.