Is it scandalous? Yes. Should you be outraged? Absolutely. Were you economically harmed? For most hedgers, the answer is not likely. We’re talking, of course, about the LIBOR fixing scandal that has ensnared Barclays, and may very well indict other banks before all is said and done. Over $350 trillion worth of financial contracts are tied to LIBOR, so it’s not a stretch to say a scandal like this could shake the very foundations upon which modern capital markets are built! And just like an earthquake’s destructive power is measurable, on a 10-point scale from micro (1) to massive (10), this scandal, too, will be judged accordingly. But so far, it’s about a “2” – generally not felt, but recorded, for the majority of market participants who were hedging. While that could change with aftershocks (and there will be aftershocks, if more banks are implicated and exposed), the building codes for LIBOR construction, your financial contracts in general, and interest rate hedging specifically, have to a large degree, insulated you from the tremors and misdeeds that you may have read about.
LIBOR construction. The LIBOR index is created on every good London business day, in 15 different tenors ranging from overnight out to 12 months, across 10 different currencies. Contributor banks on the specific currency panels will submit input for this index each day, answering the question “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11AM?” The British Banker’s Association (BBA), through its calculation agent Thomson Reuters, will calculate the index for a given tenor and currency, by throwing out the top and bottom quartiles of submitted bank rates, and averaging the middle rates. During the years in which the Barclays LIBOR fixing took place, the USD panel consisted of 16 banks, so Thomson Reuters would have thrown out the top four and bottom four submitted rates for a given tenor, and averaged the remaining eight to derive the published index. The USD panel has since added two more banks to make 18 contributor banks today. This means that a single contributor bank, submitting tainted estimates of its own borrowing costs, would contribute a number that was either averaged with numbers from other panel banks, or ultimately discarded in the process. While a single bank would not know other banks intended submissions without collusion, a single panel bank could nonetheless attempt to manipulate the index average higher or lower on its own, and even intentionally submit rates it expected to be thrown out in the calculation process. But would that be enough to change your LIBOR reset?
Your financial contract. To determine whether or not the LIBOR fixing scandal would hit you directly, you need only examine your underlying financial contracts. How is your interest rate calculated? What date is the rate pulled from, in what currency, and for what tenor? Assuming your contract interest rates tie back to LIBOR rates from the periods of alleged manipulation, we would then need to understand the impact of any modifications made in your agreement. For any given tenor and currency, standard LIBOR applies a two-London business day look-back, utilizes 100% of index, and is published out to five decimal places. The most common modifications are on look-back days and holiday cities (less days, different cities perhaps), percentage of index (tax deferred or tax exempt transactions often apply less than 100% of index), and rounding conventions (LIBOR is published to five decimal places, but your contract may round to less places). Both percentage changes and rounding would tend to mute the impact of any tainted index, applying less of the index or diffusing the rate with obscuring rounding instructions. So even if your contract interest rate applied a LIBOR rate that was manipulated, your contract language may have materially altered the rate and changed the impact or outcome.
Interest rate hedging. If you have reviewed the LIBOR construction rules and determined your underlying financial contracts were still at risk based on your contract language, then the tenets of hedging should put any remaining concerns to rest. We often talk about hedgers as being indifferent to rate movements when they have executed agreements in place. For example, if you locked rate in a pay-fixed swap at 5.00% vs. 1 month LIBOR + spread, then the underlying LIBOR index can shoot to the moon, and you are fully protected, still only paying the contractual 5.00% all-in on swap and loan. The same story happens if the LIBOR index was manipulated. If LIBOR were manipulated higher, you would pay more interest on your loan agreement, but receive more interest on the floating leg of your swap agreement, in equal and offsetting amounts. If LIBOR were manipulated lower, you would pay less on the loan agreement and receive less on the floating leg of the swap agreement, in that case. So long as the hedge and underlying hedged item match, this scandal can cause you no economic harm.
Aftershocks. No doubt there will be aftershocks from this scandal. Other banks may be implicated and exposed as having manipulated their submissions to the BBA as well. And collusion, where several banks agreed on contribution rates together, would be much more damaging and likely to skew the calculated index in a specific direction. Importantly, the direction of manipulation (over- or under-reporting the bank’s borrowing costs) may have been different at different times. Reporting persons within the bank may have done favors for their friend-traders, contributing rates that could benefit specific positions, but not necessarily the whole bank (and, in fact, to the detriment of other bank positions held). It is also possible that banks themselves may have misrepresented their borrowing costs lower through their contributed rates, during the peak of the financial crisis when any hint of weakness (i.e., higher reported rates) could mean a market move against the bank. If your positions withstood the Barclays revelations and the scandal to date, will they withstand the aftershocks of other bank admissions?
The real loss – market confidence. The aftershocks are yet to arrive, and we may still find that rate manipulation did cause economic harm to certain individuals, whose combination of contract direction, interest rate definition, rate reset timing, and lack of or mismatch in hedging all align precisely to greatest effect. Given such a finding, the last protection from rate manipulation risk would be the magnitude of your deal – how large and thus how material could such an overpayment be? Don’t forget to subtract those periods where you may have benefited from an underpayment as well, as manipulation appears to have gone both directions. Only then can you judge the true impact on your specific deals. As for the scandal itself, while the majority will still find that their house was shaken to no real effect, the LIBOR tremors are nonetheless a very real earthquake, and a new fault line was exposed in what seems to be a never-ending story of lost confidence and breach of public trust. Only when we address the root causes, and enact meaningful deterrence and reforms, will we see these threats subside, and only then can damaged perceptions be restored.
Everyone’s situation is different. If you are unsure whether your deals could be materially impacted by these events, please give us a call at +1 610.925.3120. If we can assist you in any way…