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Question of the Week - August 21, 2017

Question of the Week - August 21, 2017

Website Administrator - Monday, August 21, 2017

Is LIBOR going away? By the way, what is it, anyway?

LIBOR stands for the London Interbank Offered Rate, and represents several averages of interest rates that large banks in London charge each other for short-term loans. Although it's referred to in the singular, it's a series of rates for different terms ranging from 1 day to 1 year. In that sense, it's similar in some respects in concept to the fed funds rate used by banks in lending to each other in the U.S., although the fed funds rate is a single rate as opposed to a variety of rates. Due to its long history, particularly 1-month and 3-month LIBOR have been used as 'base rates' for a variety of variable-rate global financial transactions, from floating rate bank loans to commercial debt to even home mortgages. In recent years, up to $350 trillion of global monies have been tied to LIBOR rates, making this significant from a financial industry perspective.

For example, a quote of '3-Mo. LIBOR+300' would imply that the loan's interest rate would 'float' along with the current LIBOR rate, plus a credit spread. If the starting LIBOR rate was 1.00%, the quoted rate for that loan would be 4.00% (1.00 + 3.00% of credit spread). If shorter-term interest rates moved higher, say LIBOR up to 1.50%, the new effective rate would become 4.50%, and so on. Variable rate loans are subject to a great deal of interest rate risk for the borrower that is always at the mercy of interest rate markets moving higher, while investments based on variable payouts have the opposite impact, with far lower interest rate risk because of lower implied durations and frequent 're-sets'. Swaps are another financial derivative frequently based on LIBOR, where one party might elect to hedge other balance sheet obligations through a private contractual agreement for a set time period. In a basic 'plain vanilla swap', one party receives a fixed interest rate, of say a few percent, while other receives a variable rate of LIBOR plus a spread. These are settled at periodic intervals based on which party came out the 'winner'.

However, as opposed to the single fed funds target rate, which is set by the Federal Reserve's FOMC, LIBOR is 'looser' in some respects in that it's set by banks themselves through an antiquated-sounding survey process and 'judgement' rather than market activity directly. Unfortunately, this looseness led to manipulation and alleged collusion by a variety of banks in their setting of these rates—a case that was settled in 2012. During the financial crisis years, it was alleged that rate quotes were kept artificially low relative to actual rates charged, but debate about the impact continues.

The search for a suitable replacement has been in the works since, as regulators in the U.K. have announced a phase-out or restructuring of LIBOR by the end of 2021. U.S. regulators (specifically, the Alternative Reference Rates Committee) have proposed a broad treasury-based repo rate as a possibility, but that remains in a preliminary status. Expect more on this topic in years to come, as the dollar amount affected is quite large, to the degree where a basis point or two can mean large profits or losses to affected parties, including borrowers, investors, hedgers and speculators. This may end up being a fairly big deal or a complete non-issue, based on how quickly and officially regulators act.

Read our Weekly Review for August 21, 2017.

Read the previous Question of the Week for June 26, 2017.

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