Thursday, July 5, 2012

LIBOR in crisis

Right on the margins of media coverage of business you'll see frequent analysis of an esoteric corner of finance:  the Libor crisis. Or Libor scandal? Are we ready to term what has happened and what has surfaced an outright scandal?

As much as ethics are studied in courses in business school and debated in op-ed columns and books, we turn the page and find yet another scandal, accusation of fraud, or sleight of hand by bankers or traders to manipulate markets.  Libor, this month. In previous months, we watched the insider-trading convictions involving hedge-fund manager Raj Rajaratnam and former Goldman Sachs board member Rajat Gupta. Years after the scandals of Enron and Worldcom (and decades after Drexel Burnham and Ivan Boesky), there continues to be the periodic crisis of ethics in finance.

For those not familiar with the nuances and mechanics of debt finance and interest-rate swaps, "Libor" refers to the London Interbank Offering Rate, a base cost of funding among top financial institutions, calculated in part based on the margin cost of funding at major global banks. Banks that are members of what is called the BBA (British Bankers' Association), including Citi, Barclays, JPMorgan Chase and others, calculate internally their respective marginal interest-rate costs of funding banking transactions and report those figures to the BBA.

The figures from each bank ultimately contribute to the calculation of one Libor rate. A bank's marginal cost is based, in part, on its access to funding (deposits, borrowing from other banks, long-term borrowings, commercial-paper investors, capital, etc.) and the weighted-average costs of its borrowing structure. The reported Libor base rate is a calculation based on the submitted rates of each bank.

Libor, through the years, has become a standard rate used as a basis to set the interest rates on billions of dollars in loans and bonds and, reportedly, trillions in interest-rate-related derivatives. A standard base rate makes it easier for banks, traders, lenders, underwriters and trading-counter-parties to negotiate and agree on interest rates in finance transactions. The BBA  supervised the regular, routine calculating and reporting of Libor, and the rate was used as a standard in transactions all around the world.

When a group of banks (in syndication) and a large corporate borrower negotiate a large floating-rate loan, for example, they don't need to squabble over what floating rate. Libor is a convenient, fair, realistic base rate.  (The banks, of course, will add an appropriate "spread" above the three-month Libor base rate.)

Some, especially those who know U.S. commercial banking, are familiar with a bank's "prime rate," which for many years was a bank's base rate offering for commercial and consumer loans.  It, too, was calculated based on a bank's marginal cost of funding.  Libor is more expansive, more global, and tended to be assigned to the largest of bank transactions (the billion-dollar syndicated loan to IBM or the billion-dollar floating-rate bond issue from Pepsico).

If you glanced at the headlines, you would have seen recent announcements of Barclays admitting to manipulating the calculation it does when it reports to the BBA. And you would have seen the settlement it agreed to pay regulators and the subsequent resignation of its chairman and CEO Robert Diamond. Regulators in the U.S. and in the U.K. concluded Barclays submitted lower rates than it should have to give the impression its funding costs are low because of its strong financial health. Barclays, they claimed, didn't want to alert investors or trading counter-parties that it might have had to pay more to fund its balance sheet because of apparent financial difficulty.

As anyone who followed the collapse of both Lehman Brothers and Bear Stearns knows, financial institutions, even those capitalized in the tens of billions, cannot hint to markets they have difficulty funding the balance sheet. The mere suggestion of trouble can spawn a "run on the bank" (short-term investors demand payment immediately) or a demand by investors, depositors, or lenders to pay higher, onerous funding rates.

Barclays is cooperating, and regulators and others have moved on to investigate whether other banks did the same.

The calculation and pegging of Libor is, by no means, an idle, unimportant exercise. Libor is used as the base rate in just about every significant syndicated-finance loan, just about all corporate bonds of substantial size to major corporations, and just about all interest-rate and currency swaps traded in the derivatives sphere.  It's also the base rate for just about all structured-finance activities, from mortgage-backed securities to the securitization of car loans and credit cars.  To those deeply immersed in finance, funding, and trading, you don't escape Libor.

The calculation, updating and reporting of Libor had been so routine that many may have perceived it as a dull, perfunctory task, repeated day to day, a process managed by systems and computer algorithms until a senior bank official routinely blessed what that bank reported to the BBA. Few, if anybody, across the world thought about the process of updating and reporting Libor.

In fact, the process had likely become so routine and so taken for granted that someone somewhere might have thought little of fudging the updates by tinkering with a few basis points in the report to the BBA or thought that a smidgen of fudging by one bank would have insignificant impact on the final, reported Libor figure.

So while regulators explore whether the apparent scandal is more widespread than we thought, what happens next?

As one research analyst reported this week, Barclays settled, and if other banks are involved, they may elect to settle relative to the nominal Barclays total ($450 million).  But as with any crisis, after regulators are done, civil lawsuits ensue.  Because Libor determines the value (and, therefore, profits and losses) in interest-rate swaps transactions, some traders will argue that they should be compensated for certain losses or lower-than-expected profits.

Barclays admits it under-stated its reported Libor contribution. That implies borrowers paid a few basis points less in interest than they should have on some deals.  But that means investors will argue they should have been entitled to more interest earned. Interest-rate swap traders will argue that certain derivatives should have been valued more before they off-load them.

And, yes, regulators, after investigations and settlements, will step back to decide how governments can ensure such manipulations and deceit will never occur again. They may recommend government-supervised Libor committees oversee the determinations of collective base rates or merely do the calculations. It's too early to perceive where lawmakers will go from here.

The issue occupies a corner of the business press; it will certainly remain in headlines for the rest of the year.

Tracy Williams

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