The Libor Furor

By Bruce Davis, Senior Partner, Lee & Associates Atlanta

The recent discovery that Libor (London Interbank Offered Rate) may be impure and has been manipulated is one more element of disgust that investors are finding with large money center controls in the marketplace. We take Libor for granted and have for so long. Perhaps it is instructive to take a closer look at just what this benchmark is, upon which so many other adjustable rate instruments are based.

For starters, one must ask, exactly how is this daily rate ascertained? Surprisingly, the rate is actually determined by a poll taken from between six to 18 banks that question, “at what rate can you borrow and lend to a ‘leading’ bank just prior to 11am?” The resulting average of the middle ten rates given to this query then become the quoted “benchmark” of the day for the previous day’s number. Obviously, not all banks polled may have loaned or borrowed funds the previous day. Therefore, the first indication is that the rate itself is, if nothing else, hypothetical. And as you can imagine the question can in no way be ‘measured’, in which case it is also subjective.

It is the combination of these two characteristics that render the Libor to be vulnerable, and for the first time since the benchmark became widely used (the 1980’s), several banks have in fact been accused and proven to have artificially influenced and manipulated the rate. The biggest culprit so far identified–Barclays, has just settled with authorities and will pay a fine of $454 million. Other banks are implicated and investigations are ongoing.

“So what,” you say? Does it affect the typical investor? The reach of this benchmark is far and wide across the world economy. Corporate and Municipal credit is based upon Libor, typically with a stated spread, as are the rate of payment to bondholders. Credit cards, student loans, 45 percent of adjustable rate mortgages, and 80 percent of subprime mortgages are all based on some measure against Libor, thus having a broad effect on a significant amount of borrowers and households.

While Barclays is so far the only institution to have admitted to the guilt of this blasphemy, the indications are that some collusion between the larger banks have taken place. Regulators in both the UK and the United States are out for blood, the flow of which, at least to Barclays, is little more than a slap on the wrist. It remains to be seen if that is going to be the norm, or if they were let off easy just to be captured for their “cooperation.” The real risk of exposure for these participating banks comes not from regulatory fines, but rather from the litigation of civil suits that will follow. Final determination of this scourge could take years to adjudicate.

In a pending irony, however, I have been told by an officer from Regions Bank (they have dodged the bullet; no implications leveled), that in the final analysis, the borrower will be ascertained to have benefitted from the artificial effects upon rate setting, rather than have incurred additional and arbitrary costs. How can that be possible? Would the guilty parties not have inflated Libor so as to charge borrowers more, thus adding to their bottom line? Not so, perhaps. It might be that the ‘appearance’ of their financial health by reporting lower Interbank borrowing capabilities became more important than interest income from borrowers. Another factor might just be that fear of derivatives exposure had a hand in the whole matter. It will be interesting to see how the investigations proceed.

Bruce Davis is a senior partner of Lee & Associates Atlanta. For more information about Lee & Associates, you can contact us at: (404) 442-2810 or visit us at www.leeatlanta.com