We’ve all read a lot (probably too much), about the LIBOR scandal in the past couple of weeks. Despite a constant stream of stories, blog posts and articles, so far I’ve only seen a couple of pieces that have really helped me to understand true effects this circus will have on investors. Part of the cause for this confusion comes from the pervasive use of the term without explanation of the nature of what LIBOR really is, and where it comes from. Let me try to help smarter investors gain some perspective.
A Bit of History
LIBOR - or London Interbank Offered Rate - was conceived in 1984 by the BBA (British Bankers’ Association) “to develop a calculation that could be used as an impartial basis for calculating interest on syndicated loans.” The methodology of the calculation is basically a truncated average from a group of banks’ estimates as to what their borrowing costs would be if they were to seek loans in any of 10 currencies over any of 15 different time spans (ranging from overnight to a year or more). Banks answer the question, from the BBA’s website, “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 am?” These estimates are collected each morning by Thomson Reuters, and the average is subsequently published to the markets. Banks and lenders then add a “spread” or additional cost to this base rate to formulate the interest rate charged on much of the world’s outstanding debt. Simply put, the LIBOR interest rates set the cost of borrowing.
The Average of an Estimated Expectation
By the above definition, it would seem obvious that LIBOR is really nothing more than a series of estimates. When viewed in this light, it almost feels ridiculous to be surprised or even outraged that there has been “manipulation” in these figures. Based on many of the revelations about the inner workings of the banking industry that have been published over the past 25 years or so (read Liar’s Poker or Michael Hudson’s The Monster, if you don’t know what I mean), it also seems naïve to think that large banks driven mostly by next quarter’s earnings would do anything other than maximize their profits at every turn. With that said, the really concerning part of this story is not that big banks were giving market numbers which were not 100 percent accurate, but rather that they were colluding to set interest rates and thereby create opportunities for profits from trading with this information.
How did this really affect you?
The outrage and anger about this situation is reasonable, and appropriate in some sense, given that those published rates are used as the basis for as much as $500 trillion of outstanding debt globally. LIBOR affects the rates charged on most every type of debt from government bonds to mortgages to student loans to credit cards. However, there is a positive effect here which is not being widely discussed: the ongoing collusion has actually reduced the effective rates on much of that debt.
Yes, a positive side effect of the collusion between the big banks has been to artificially reduce the interest rate upon which much of the world’s debt is based. The unsettling fact is that these banks have been making enough money from their other trading activities in the market to allow them to afford to make loans at lower rates than they otherwise might have done.
So far, Barclays has paid $340 million in fines, and 16 other large institutions are under investigation in the U.S. and Europe. It remains to be seen what changes, if any, to the process for setting LIBOR rates will be enacted, and how that will affect interest rates going forward. However, it is clear that this type of collusion does perceptible damage to the markets’ view of the banking industry, and adds to the feeling that the regulators are not able to stamp out market manipulation. With that said, investors should know that the concept of LIBOR remains a great idea – collecting information about lending from the biggest lenders, and then base market interest rates off of that information. Hopefully, regulators in the U.S. and abroad can find some way to keep the best part of the process, while removing the deception.
As an investor, everything I’ve read and seen on this situation tells me to continue to stay away from the financial sector as an investment given the uncertainty not only of how this scandal will play out, but also how the changes to the LIBOR rate process are likely to negatively affect their profits in the future. Additionally, it should remind you to negotiate vigorously on the interest rate for every type of borrowing you do – or hire a competent advisor to help you with the process.
Timothy R. Lee, CFP®, is a managing director and cofounder of Monument Wealth Management in Alexandria, Va., a full-service investment and wealth management firm. Monument Wealth Management is backed by LPL Financial, an independent broker-dealer and Registered Investment Advisor, member FINRA/SIPC. Monument Wealth Management has been featured in several national media sources over the past several years. Follow Tim and Monument Wealth Management on their blog Off The Wall, on Twitter at @MonumentWealth, and on their Facebook page.
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