Usually when something goes horribly wrong in the financial market, change is born. Arthur Anderson’s failures in auditing Enron, WorldCom, and Waste Management resulted in Sarbanes-Oxely. The mortgage crisis of 2008 supposedly brought about changes to prevent NINJA loans and increased the scrutiny of the relationship between lenders and appraisers. Among other things, this scrutiny resulted in laws segregating the various aspects of the mortgage lending process. Precedence followed with the uncovering of the corruption and collusion of multiple international banks in the LIBOR scandal of 2012. Due to this corruption, LIBOR lost its value as a benchmark for setting rates. As a result, changes affecting trillions of dollars of transactions are in process.
In order to understand the effect of the LIBOR scandal, we first have to understand what it is and how it is calculated. LIBOR stands for the London Inter-bank Offered Rate. LIBOR has various maturities available, which range from overnight to 12 month rates, and is also available in various currencies. These rates are a calculation based on inputs directly from some of the largest banks in the world. For example, US Dollar LIBOR is calculated as an average of 18 bank submissions of the interest rates at which they would be able to borrow capital from other banks for the applicable maturities. Before averaging the 18 rates, the highest 4 and lowest 4 rates are excluded to theoretically exclude outliers. As you might have guessed, all it takes to manipulate this rate is for a few of the banks to collude and report either higher or lower interest rates, depending on the banks’ desired outcome. At times, it was in the best interest of the banks and their traders to report higher rates to inflate their sales and their financial health, while at other times it was in their best interest to report lower rates to benefit them during derivative trades or lower cost of borrowing. This manipulation, while making the banks money, was obviously detrimental to the counterparties in the transactions. The banks were able to defraud their counterparties through this manipulation.
When this news came out, consumer trust in LIBOR was shaken, if not exterminated. Due to the ease of banks manipulating LIBOR, the financial industry determined that a new rate, impervious to manipulation, was required. Eventually the Secured Overnight Financing Rate (“SOFR”) was chosen as a replacement. However, much more work is required before SOFR will be able to function similarly to LIBOR. SOFR is a single rate with one maturity, overnight, based on the prior day’s repurchase agreement transactions of BNY Mellon, GCF Repo, and bilateral Treasury repo transactions. SOFR is reported each day at 8:00 a.m. eastern time. SOFR is proving to be more volatile due to the transaction-based calculation.
So what does this mean for companies moving forward? The industry is now transitioning most products that were benchmarked using LIBOR to SOFR or similar international benchmarks. LIBOR will eventually have no reliability and will cease to be published. At that time, all financial instruments associated with LIBOR will either need to be amended or terminated due to the phase-out of LIBOR. Depending on how entities decide to remediate the LIBOR situation, significant balance sheet and income statement effects could arise (realized gains, losses, etc.). LIBOR is set to end by 2021. SOFR will also take some time and experience before companies are comfortable with SOFR-based financial instruments. Experience with SOFR and how the rates are written into financial instruments (whether as a single date rate or an average) could have unintended consequences for entities. Companies should begin to assess the effects of the LIBOR phase-out now in order to prevent significant and unanticipated consequences.
For more information, contact your Larson advisor.
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