The Uses of LIBOR and the Victims of Its Manipulation: A Primer
Thursday, August 23, 2012
Little attention has been paid to why LIBOR is important, who might have been harmed by its manipulation, or how to think about the financial ramifications.
Financial institutions around the world are caught up in a scandal concerning the manipulation of an esoteric interest rate, the London Interbank Offered Rate (LIBOR). LIBOR affects the payout of around $800 trillion of securities, and small manipulations can cause billions of dollars to change hands. Allegations against the financial institutions and traders involved are serious, as are the claims that regulators turned a blind eye to misconduct. While the initial media attention has dissipated, new developments will likely continue for months if not years as regulatory scrutiny, criminal cases, and lawsuits proceed.
While there is a great deal reported about manipulations of LIBOR , little attention has been paid to why LIBOR is important, who might have been harmed by its manipulation, or how to think about the financial ramifications.
This primer aims to fill that gap. It is not about the scandal, but about LIBOR itself. It’s meant to explain the finance behind the scandal. It describes how and why LIBOR is used and illustrates how its manipulation might have affected borrowers, lenders, and participants in the derivatives market.
1) Introduction: What is LIBOR and how can it be manipulated?
The LIBOR is meant to be the average interest rate at which large banks in London might borrow from other banks.
It is calculated at 11 a.m. every day by taking a trimmed average of the responses from contributing banks regarding their estimated borrowing costs. Rates are reported for 15 lengths of borrowing, ranging from overnight to 12 months, and in 10 different currencies. The LIBOR USD 3 month, for example, is the average rate at which participating banks can borrow U.S. dollars for three months. Depending on the length of borrowing and currency, a panel of between 6 and 18 banks is asked the following 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 11 a.m.?”
Of the 6 to 18 banks, the bottom and top quartiles of submissions are dropped in order to limit the undue influence of any single bank on the overall rate. The reasoning is that by culling outliers, any submission that is unduly high or low will have no effect on the LIBOR that is reported.
Unfortunately, that mechanism has proven ineffective in preventing manipulation, which banks undertake to increase the value of their assets or to improve the appearance of their financial situation.
First of all, banks can collude to move the trimmed average, and traders at several financial institutions are being investigated for doing so from 2005 to 2011.
Banks can collude to move the trimmed average, and traders at several financial institutions are being investigated for doing so from 2005 to 2011.
Second, in times of crisis, there is pressure on all of the contributing financial institutions to report lower rates, collusion aside. This is because borrowing costs are an indicator of financial health. High LIBOR submissions signal that a bank is weak and can motivate investors to flee, causing further degradation to the bank’s balance sheet. Since every bank is motivated to have low submissions relative to its peers, a race to the bottom begins. The British bank Barclays has admitted to underreporting for this reason during the recent financial crisis, but it was merely the first to cooperate with regulators and other banks are entangled as well.
Finally, LIBOR can be manipulated by a bank acting alone. In fact, Bloomberg has reported that only 11 of 173 emails asking Barclays’s rate-setters to manipulate the U.S. dollar LIBOR came from outside the bank. Although the trimmed average prevents any single bank from having an unbounded ability to control the average, it does not entirely eliminate the influence that a single bank can have. In fact, a bank can influence the rate by adjusting its submissions all the way to that of the first excluded bank. Consider a situation where there are six banks, and the top and bottom submissions are excluded. The banks submit rates of 1%, 2%, 3%, 4%, 5%, and 6%. The trimmed average is therefore 3.5%. But let’s say the third bank wants to manipulate LIBOR downwards. If it changes its submission from 3% to 0.5%, then it gets kicked out of the average and the bank with a borrowing cost of 1% gets brought in, pulling the entire average down to 3%.
LIBOR, then, can be manipulated in several ways. But that begs the question, why does it matter if LIBOR is manipulated? The reason is that somewhere around $800 trillion of assets are linked to it, using it as a reference rate and depending on it to determine their payouts and value. In the coming months and years, those linkages are likely to haunt Barclays and the other banks that become entangled in this scandal. Past holders of LIBOR-linked securities are beginning to calculate how much manipulation might have harmed them, and the lawsuits have already begun.1
The statistics regarding the magnitude of linkages are quite shocking, and they are often reported in the press, as is the potential for lawsuits and criminal action. What is not explained is why so many assets are linked to LIBOR, how manipulation affects people through those linkages, and who would be hurt or advantaged by manipulation.
The answer to the first question is that assets are linked to LIBOR due to its potential to protect the value of investments from the effects of changes in interest rates, or, in finance-speak, as a means of hedging interest rate exposure. Section two explains why interest rates might need to be hedged. Sections three and four explain how reference rates can be used as a tool when hedging, and section five describes why LIBOR, in particular, is used as a reference rate. Section six illustrates who might be advantaged and disadvantaged by different sorts of manipulation, and the final section offers conclusions.
2) How do interest rate changes affect borrowers and lenders?
Before exploring the types of securities that are linked to LIBOR, it’s important to understand the motivations for linking a security to an interest rate to begin with. And that, of course, requires some knowledge of how interest rate changes affect borrowers and lenders. As most people know, a dollar tomorrow is not worth the same as a dollar today, and debt is just an exchange of money today for money tomorrow. How much less it is worth relies on the risk-free rate of return that is available in the market.
The quintessential risk-free asset is the U.S. Treasury note, which is a debt security backed by the U.S. government. In the 1970s and 1980s, Treasury notes were extremely volatile and the 10-year Treasury yield spiked to 15.84%—it’s been around 1.5% in recent months. It was during this period that LIBOR gained importance because the volatility of interest rates came as a shock to borrowers and lenders. The reason for this is intrinsically wound up in the time value of money.
A simple numerical example illustrates why interest rate volatility matters, and the example should also help to build some core concepts that will be useful later in this primer. Consider a bank that offers a simple loan: $100 for ten years at 10% interest a year. So, in return for $100 up front, the bank receives $10 interest payments, or coupons, at the end of years one through nine and $110 at the end of year ten. That’s the final coupon plus the $100 return of principal. The stream of payments, from the perspective of the bank, looks like this:
But each of those payments is worth less today than the dollar amount would suggest, even assuming the borrower does not default. The profit from this stream of payments cannot be determined by simply adding up the coupons over ten years and claiming a neat $100. The reason for this is that the money could otherwise have been invested at a risk-free rate of return.
If that risk-free rate of return is 1.5%, then a $10 coupon one year from now is only worth $9.85 today. This follows from simple algebra. We solve for the value today, x, which would be worth $10 in one year if invested at 1.5%:
Likewise, the value today that returns $10 in two years when invested at 1.5% can be found by solving:
Applying this pattern to the loan discussed above allows us to find its present value, or how much the stream of payments is worth today, again assuming that the borrower has no risk of default:
A loan worth $178.39 is a great deal for the bank, which only paid $100 for the income stream. But what if the risk-free rate were to spike to the 1980s high of 15.84% immediately after the loan was made? Then $10 next year would only be worth $8.63 today since it could be invested at a higher risk-free rate, and the present value of the overall loan would fall drastically. The bank would be losing money through its obligation, while the borrower would be quite happy. The calculation for the present value in this scenario is below:
If the risk-free rate falls rather than rises, it would be the borrower who rues having locked in interest rates.
Loan pricing, of course, is always more complicated than these examples suggest. The structures of loans vary widely, and a borrower with no risk of defaulting is nonexistent.2 However, the simplicity of the examples highlights a key fact: For fixed-coupon debt, borrowers benefit when interest rates rise, while lenders benefit when interest rates fall.
3) How can borrowers and lenders hedge interest rates by linking debt to a reference rate such as LIBOR, and why do they do it?
In order to protect themselves from uncontrollable swings in interest rates, the bank and borrower from our previous example have many options. One is that they could choose a shorter length of loan—let’s say a half-year—and then repeatedly “roll it over” by continuing to enter into new loans at updated interest rates until the ten years have elapsed. As we saw above, the effect of interest rates compounds as payments are farther out, so rolling over bonds drastically reduces the effect of interest rates on their value.
During the height of the financial crisis, it seems that the banks systematically underestimated their borrowing costs in order to appear healthy to investors. Regulators seem to have turned a blind eye.
Yet there’s a much simpler way to achieve the same effect, and that would be to enter into one loan contract for ten years, but agree to a floating rate. In a floating-rate loan such as this, the coupon is reset periodically to reflect some reference rate and an additional spread, so that the coupon is the reference rate plus or minus x percentage points. For example, if the reference rate is 10-year Treasuries and the spread is 8.5 percentage points, then the coupon today would be 10%. If 10-year Treasuries were to spike to 15.84%, then the coupon would climb to 24.34%.The coupon on the floating-rate loan floats upwards and downwards according to the swells and troughs of the reference rate. Many different reference rates are used, but LIBOR is one of the most common for reasons that are explained later.
There are many examples of floating-rate debt, and they often come by different names depending on their use. When the loan is sold to a public market as a bond rather than held by the bank, it is called a floating-rate note (FRN), or a floater. Typically these are issued by corporations. When the interest rate on a mortgage is linked to a reference rate, the mortgage is called an adjustable-rate mortgage (ARM). Floating rates can also be found on credit card debt, auto loans, and student debt.
Some borrowers are more exposed to the effects of interest rates than others. For example, an individual who relies on a steady wage to pay his bills is more likely to prefer a fixed-rate payment on any loan or mortgage because wages are relatively “sticky” and do not reset quickly in response to interest rate changes. If his coupon payment rises sharply but his wage is not renegotiated, then he might not have enough cash to pay the coupon—or, in other words, he will face a liquidity crunch. Likewise, a firm that has negotiated fixed contracts for its services will prefer to make fixed payments on its debt. On the other hand, a small business owner whose inventory turns over quickly and who can reset prices easily might prefer a floating-rate payment, because he can adjust the prices to match the value of his inventory. Essentially, borrowers want to match the interest rate sensitivity of their debt with the interest rate sensitivity of their assets, which in the first example was the man’s employment, in the second was the firm’s contracted future receipts, and in the last was the inventory.
Lenders, too, try to match the interest rate sensitivities of their assets and liabilities. The primary liabilities of banks, for example, are typically deposits owed to customers, which are not very sensitive to interest rates due to their short-term nature. Conversely, many of a bank’s assets are loans, mortgages, and other forms of longer-term debt, whose values are very sensitive to interest rates. This mismatch, when it exists, exposes banks to interest-rate risk and is one of the reasons they are eager to lend at floating rates.
4) How can reference rate-linked derivatives be used to hedge interest exposure?
In addition to adjustable-rate debt, a number of derivative products allow investors to hedge their interest rate exposure. These products rely on reference rates, such as LIBOR.3 First, it’s worth noting that a derivative is just a financial product whose value is derived from some underlying asset, but that does not actually provide an ownership stake in that asset. Among the most prominent derivatives that are used to hedge interest rate exposure are interest rate swaps, interest rate futures, and forward rate agreements.
i) Interest Rate Swaps
In an interest rate swap (IR swap), a party that borrows at a floating rate and a party that borrows at a fixed rate effectively “swap” their payment responsibilities. The party with the fixed-rate obligation pays the party with the floating-rate obligation a floating rate, and the party with the floating-rate obligation pays the party with the fixed-rate obligation a fixed rate. The net effect is that their exposures are switched; the party with the floating obligation now has a fixed obligation and vice versa. Typically the counterparties to an interest rate swap will be firms or municipalities whose assets and other liabilities have changed since issuing debt and are now either more or less exposed to interest rates. Oftentimes the parties don’t trust each other, so a bank will place itself in the middle, receive and pass on each of the swap payments, and take a small cut in exchange for absorbing the “counterparty risk”—the risk of one of the parties defaulting on its obligation.
Whenever the initial floating-rate debt is linked to LIBOR, the floating rate that is paid in the swap will also be a floating rate linked to LIBOR.
ii) Interest Rate Futures
A future is just a standardized contract to buy or sell something in the future for a price agreed upon today. This allows buyers and sellers to lock in their exposure to the price of an asset in advance of an actual sale, and it is useful for hedging many kinds of risks. Farmers sell futures in advance of harvest season on the price of corn, and airlines buy futures on the price of fuel. What’s more, futures are traded on an exchange, which acts as an intermediary between the two firms and absorbs the counterparty risk, much as banks sometimes do with IR swaps.
An interest rate future is no more complicated than a future for corn or fuel, and simply allows buyers or sellers (borrowers or lenders) to lock in the price of debt (i.e., interest rates). If the uncertainty of future interest rates adversely affects you—either because you need to borrow or lend money or because you’ve already borrowed or lent money at a fixed rate—then you can lock in those future rates with interest rate futures.
A prominent version of interest rate futures relies on LIBOR USD 3 month, and is called a eurodollar future. Eurodollars are just U.S. dollars that are deposited in banks outside the United States for a fixed period of time, where they face less regulation and earn a higher interest rate than similar deposits in the United States. Since LIBOR USD reflects the interbank borrowing rate of U.S. dollars outside the United States, it is highly representative of the overall borrowing rate for eurodollars and therefore used as a reference rate for eurodollar futures.
Past holders of LIBOR-linked securities are beginning to calculate how much manipulation might have harmed them, and the lawsuits have already begun.
Someone who buys or sells a eurodollar future is just hedging their exposure to changes in the LIBOR USD 3 month rate, which is a major component for the cost of lending or borrowing eurodollars. If an investor buys a futures contract that “settles” in one month, then he is agreeing to pay the difference between the current market expectation of what LIBOR will be in one month and what LIBOR actually turns out to be in one month. A firm that knows it will need to borrow money starting in six months could buy eurodollar futures with a settlement date in six months. Then if LIBOR becomes more expensive than expected (the rate is higher), the firm earns money from the futures contract but its loan is more expensive. If LIBOR is cheaper than expected, then it gets a better deal on the loan but loses money on the LIBOR contract.
iii) Forward Rate Agreements
Forward rate agreements (FRAs) are closely related to both interest rate futures and interest rate swaps. In an FRA, one party pays a fixed interest rate, determined in advance, and the other pays a floating interest rate equal to the reference rate at some effective date. They make a net exchange of payments at a predetermined date after the settlement date. The reference rate used is determined based on the length of time between the effective date and the settlement date. A “3 x 6” FRA would have an effective date in three months, a settlement date in six months, and the reference rate would be an interest rate on the cost of borrowing for three months, such as the LIBOR USD 3 month.
Although this might seem similar to a eurodollar future, it is different in a number of ways. The LIBOR USD 3 month rate was not the only reference rate to choose from. A forward rate agreement, for example, could be a “3 x 9” with a six-month Treasury used as the reference rate. In the case where LIBOR USD 3 month is chosen, an FRA is still subtly different from a eurodollar future. For one, it is not traded on an exchange, so counterparty risk is a concern. As a result, banks will often act as intermediaries. Secondly, the timing of the payout is different under an FRA than it is in a eurodollar future, so the present value of the payout differs.4
FRAs are perhaps more similar to interest rate swaps than they are to interest rate futures. In fact, an IR swap can be thought of as a series of FRAs. An IR swap based on a three-month reference rate that lasts for two years and starts in three months is really the same as a “3 x 6” FRA, a “6 x 9” FRA, all the way through to a “24 x 27” FRA.
There are other methods for hedging interest rate exposure that do not rely on a reference rate, but they are outside of the scope of this primer. Additionally, there are some cases where LIBOR is used in specialized financial products that do not primarily pertain to interest rates, but those uses are secondary.5
5) Why is LIBOR used as a reference rate?
LIBOR is just one of many rates that debt and derivatives can be linked to in order to provide hedges to interest rate exposure. Now that it is clear why reference rates are used, the prevalence of LIBOR must be explained.
In the case of eurodollar futures, it is clear why LIBOR is used as the reference: A eurodollar is essentially a short-term loan to a bank. It makes quite good sense that the rate at which banks “borrow” deposits will be intrinsically linked to the rate at which banks can borrow from each other, and since much of that borrowing occurs in London, LIBOR is a clear choice.
It is less obvious why LIBOR is used in other contexts, such as credit card loans in the United States. At first, it would seem to make sense that the rate should be chosen to most closely match fluctuations in the discount rate. That depends on the risk-free rate of investment in the economy—or, in other words, the rate at which investors can lend, not at which banks can borrow. This would provide the cleanest interest rate hedge.
But when considering the business model of banks, which is fundamentally to borrow money at one rate and lend it at a higher rate, then it starts to make sense why they like to use LIBOR as a reference rate. In a way, it allows them to pass their business risk on to borrowers. When banks’ costs go up in the absence of other interest rate hikes—due to liquidity requirements, other government regulation, or animal spirits—LIBOR rises, payments due to them from LIBOR-linked loans rise, and the banks make more money. Typically, banks would have to price the expected risk into the fees or premiums that they charge borrowers, but LIBOR allows them to hedge their business risk directly.
This reasoning would seem to indicate that LIBOR is more useful for loans than traded securities like bonds, and that it makes less sense in a world where loans are often packaged and sold on a secondary market.
Of course there are other reasons why LIBOR might be used— convention being one—and too much weight should not be given to any single explanation.
6) How does LIBOR manipulation affect the payout of LIBOR-linked securities?
The last aim of this primer is to provide a simple way to think about the effect of LIBOR manipulation on LIBOR-linked securities. Two types of manipulation are reported to have occurred. One is that banks would consider the balance of LIBOR obligations that they owed and were owed on any given day and would attempt to fix LIBOR accordingly, either acting alone or in collusion with other banks. Very roughly, if a bank is supposed to receive LIBOR on $1,000 of securities on any given day and pay LIBOR on $1,500 of securities, then a 0.01% change in LIBOR would net a profit of 5 cents ($500*0.01%). The documents from the Barclays case seem to indicate that a basis-point (0.01%) change in LIBOR could net Barclays “about a couple of million dollars.” This type of manipulation, however, was likely idiosyncratic, with the rate being fixed up or down temporarily based on the shifting balance sheets of reporting banks. Due to the fleeting nature of any changes to LIBOR, it’s difficult to assess the effect on investors, although lawyers and economic consulting firms are probably trying their best.
If the uncertainty of future interest rates adversely affects you, then you can lock in those future rates with interest rate futures.
The second kind of manipulation, however, was unidirectional, and its effects are easier to understand. During the height of the financial crisis, it seems that the banks systematically underestimated their borrowing costs in order to appear healthy to investors. Regulators seem to have turned a blind eye, perhaps in an attempt to maintain the health of the overall financial system.6 Since no bank wanted to stick out as having an abnormally high borrowing cost, there was strong downward pressure on all banks to underreport, and The Economist has reported that submissions “may have been 30-40 basis points too low on average.” That is, 30 to 40 hundredths of a percentage point.
Contrary to what goes on in many financial scandals, underreported rates in this case would have helped retail borrowers such as students, homeowners, car-owners, and others who had borrowed at floating rates. For the sake of exposition, let’s say that LIBOR was underreported by 30 basis points for three months. If a student had a $40,000 loan linked to LIBOR that reset quarterly and paid a quarterly coupon, exactly one of his coupon payments would have been reduced by 30 basis points. Since a quarterly coupon is paid on a quarter of the $40,000, the student would have saved 0.3% of $10,000, or $30.
While floating-rate borrowers would have gained, the bank that held that loan, as well as anyone else who held floating-rate debt in an investment portfolio, would have lost money due to the underreporting of LIBOR. These investors would include your average Joe saving for retirement in a 401(k), pension funds, hedge funds, mutual funds, endowments, and more. According to the U.S. Commodity Futures Trading Commission (CFTC), $10 trillion of loans are indexed to LIBOR, so the gains and losses, while relatively small for one student, could be quite large in aggregate. Of course, not all of the debt that is linked to LIBOR would have been affected by temporary manipulation, and the amount that it was affected would depend on the exact structure of the debt. Many loans have “ceilings” on the rate that can be charged, for example, and if the rate was over the ceiling with or without manipulation, then there would be no effect.
The loan market, however, is just one part of the picture. The derivatives market dwarfs it in size, comprising around $800 trillion of derivatives. And just as with debt, there will always be a winner and a loser on each side of a LIBOR-linked derivative. Someone who entered into an interest rate swap paying a floating rate would be better off than if there had been no manipulation, as would the seller of a eurodollar future who bets on LIBOR rising, or the buyer of a forward rate agreement who locks in the forward price of borrowing. Symmetrically, the parties on the other side of these contracts would lose, and are likely to sue.
The LIBOR scandal will likely be an ongoing issue, as more banks are investigated and criminal charges proceed. Beyond the embarrassment and fines, the banks are likely to be caught up in lengthy litigation that could prove to be extremely costly. The actions of regulators will also be examined. Did regulators turn a blind eye during the financial crisis in order to lower the possibility of bank runs? And, afterwards, did they allow further manipulation for fear of rocking an unsteady industry that was attempting to recapitalize? The future lawsuits, upcoming criminal cases, and probable reform debate will require that all parties involved understand the financial concepts at the heart of the scandal.
The motivation for LIBOR’s use is the time value of money and the potential for interest rate changes to influence the value of future obligations. Floating rates can be set to references, such as LIBOR, to hedge exposure to interest rate changes. The reference rates can also be used to construct derivatives that provide investors more flexibility for hedging their interest rate exposure; these include swaps, futures, and forwards. While it’s difficult to tell who would have been harmed by idiosyncratic LIBOR manipulation, downward pressure on LIBOR during the financial crisis—as banks potentially lied to appear healthier—would have helped borrowers and hurt lenders.
Matthew Jensen is a research associate at the American Enterprise Institute. He would like to thank Sam Sharpe and Caroline Walker for excellent research assistance.
FURTHER READING: Alex J. Pollock asks “Who Knew When about the LIBOR Problems?” and contributes “Shift from Viewpoint of the Borrower” and “Fearful Symmetry: Six Decades of Treasury Yields.” Jonah Goldberg says “Blame Barclays, Not Capitalism.” Scott Shane discusses “When High-Interest Payday Lending Pays.”
Image by Darren Wamboldt / Bergman Group
1. For a description of some upcoming lawsuits, see http://money.cnn.com/2012/07/05/investing/libor-lawsuits/index.htm.
2. We may call the U.S. government’s Treasury obligations “risk free,” but even those have some default risk, and not all financial theories define “risk free” in the same way.
3. Sometimes investors seek rather than shun interest rate exposure based on their market outlook, and in these cases they are acting as speculators rather than hedgers.
4. The futures contract is “marked to market,” so the payment is given and received on changes in the market expectation of what LIBOR will be on the settlement date even before that day has been reached. In a forward rate agreement, payment occurs on the termination day based on what reference rate was previously set.
5. For example, LIBOR is used in some exotic inflation swaps.
6. Timothy Geithner, then head of the Federal Reserve Bank of New York, is accused of being aware that banks were manipulating LIBOR but only alerting officials in Britain that the rate could be manipulated. Officials from the British Central Bank claim that, in their communications with the New York Fed, there were no “suggestion[s] of fraudulent behavior.” Additionally, Barclays has declared that it received tacit support for underreporting its rates from its regulators and the Bank of England.