March 14, 2011

Do you remember when you first heard that Pluto was no longer a planet? Maybe your child brought the news home from school, or you read it online, but either way your first thought was probably, “huh, that’s interesting.” Then, after pondering it another moment, your world changed in an instant. How could they just decide to drop a planet? I mean, I had to memorize that planet as a kid: “My very excellent mother just served us nine pizzas.” It doesn’t make sense without the pizzas (Pluto). In that moment, you were reminded that the facts that make up your life can, and sometimes do, unravel. Pluto’s gone (well, demoted really), which means my faith in what I know to be right and true in my world is shaken, just a bit, and I need to re-interpret the facts and re-anchor my life on what is now known.

A similar thought may have occurred to you when you first heard that Libor may have been manipulated by contributor banks. Seriously? Libor? Aren’t there, like, trillions of dollars of debt and derivatives indexed to Libor? This past week, Swiss bank UBS AG revealed in its annual report that it is being investigated by U.S. and Japanese regulators, for possible manipulation of Libor in the 2006 – 2008 time frame. Along with UBS, Bank of America and Citigroup are also targets of this investigation by the SEC, according to the WSJ. The allegations are quite simple: regulators are investigating whether the banks understated their borrowing costs by submitting artificially low rates to the British Banker’s Association (BBA), thus hiding any signs of their own financial weakness from investors and the public.

To understand the implications for borrowers and banks, a quick primer on Libor follows. The London Interbank Offered Rate is the rate at which banks should be able to borrow unsecured from other banks in the London wholesale market. The rate is published every good London business day at 11AM. In the case of the USD Libor panel, contributor banks (recently expanded from 16 to 20 banks) individually advise the rate at which each could borrow funds, across 15 different tenors ranging from overnight out to 12 months. The contributed rates are then ordered, the top and bottom quartiles are discarded, and the middle two quartiles are averaged and reported out to 5 decimal places for each tenor as today’s Libor fixings. In all, the BBA establishes daily fixings in 10 different currencies using a similar methodology.

So what’s the big deal? What are a few low-ball levels in a formula that throws out the lowest ones anyways? Well, the fact that any bank could report inaccurate borrowing costs means that they all could, which in turn could impact the daily calculated rates. Also, since it is doubtful that each bank each day had borrowings in each currency for each tenor (see where this is going), the bank’s own guesstimates could find their way into the calculation on which trillions of dollars of debt and derivatives are based. Implicit in the bank-to-bank borrowing rates is a self assessment of each contributor bank’s own creditworthiness, which if underreported would mean nearly everyone’s credit model of everyone else would show a rosier picture and less risk in the banking system than is really the case. This could aggravate the situation with TooBigToFail banks, and turn mistrust of one bank into a liquidity crisis for all banks.

As a borrower, indexed to Libor, and hearing that Libor may have been manipulated downward through the self-preservation instincts of contributor banks, this still seems like a non-event (if you discount the liquidity crisis scenario, of course!) After all, that must have meant that you enjoyed potentially below true-market borrowing rates on your Libor-indexed loans and lines of credit. And if you fixed your debt service with a pay-fixed swap, the Libor-based cash flows back and forth (pay Libor on your loan, receive Libor on your swap) seem to give you another reason not to care. That is, of course, unless you held the opposite positions, and received far less interest than was warranted. Or if you had to terminate your derivative, and found that artificially low Libor translated into a larger swap liability than it really should have been.

The BBA itself has pondered and enacted several changes to Libor (adding more banks, for example), but with U.S. and Japanese financial regulators now on the case, we are sure to hear calls for greater reform in the coming weeks and months. And since much of our clients’ debt and derivatives transactions are tied to Libor, Chatham will follow these proceedings closely on your behalf. So you can focus less on contributor banks, and more on capturing business, or maybe even finish pondering the implications of your 8-planet solar system!