It was recently revealed that traders at Barclays, an international investment bank headquartered in the United Kingdom, engaged in schemes to manipulate the interbank lending rate known as Libor, or the London Interbank Offered Rate. It's analogous to the federal funds rate, the overnight lending rate in the U.S. -- except it's not overnight; the shortest is a one-month rate.
Ordinary investors, us little people, probably weren't and won't be directly impacted in the pocketbook by the rate-fixing schemes of Barclays and other banks that may have been involved.
However, bank stocks may flounder: A host of U.S. banks are rumored to be under investigation, and Barclays' share price plummeted more than 15 percent after the scandal was revealed.
The types of investors most likely to have been impacted by the Libor-fixing scheme are those with a long string of zeroes on the good side of the decimal point in their account balance and a professional interest in credit derivatives.
In a piece on DailyFinance.com on Thursday, "The LIBOR scandal is bigger than you think," Dan Caplinger wrote:
LIBOR figures are used for an estimated $350 trillion in notional value of credit-default and interest-rate swaps. For instance, both Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) hedge their extensive borrowings using swaps tied to LIBOR. All told, more than $800 trillion in loans, securities, and notional derivative contracts has links to LIBOR. Those securities include interest-paying investments which pension funds and other institutional investors own, making for an indirect impact on tens of millions of workers and retirees.
What might have been
What's unclear now is whether the rate manipulations actually had an impact and which way Libor could have been influenced.
"An entity that uses swap agreements would have been hurt if they were a pay-floating counterparty and Libor were overstated. But they would have been helped if it had been understated," says Greg McBride, Bankrate's senior financial analyst.
The opposite of a pay-floating counterparty is a pay-fixed counterparty, and they would have been hurt by Libor being understated and helped by its overstatement.
Banks and other financial institutions or entities use swap agreements to hedge exposure to interest rates.
For instance, "if you are a bank that has a very large portfolio of adjustable-rate loans subject to the movement of interest rates, you might wish to enter into a swap agreement whereby you are a pay-floating counterparty," McBride explains.
"In that agreement, you would receive a fixed payment. If they fall and you're getting less income from loan portfolio, your payments to the counterparty also drop. But the fixed payments you receive from the swap do not," he says.
There are hundreds of trillions of dollars in the derivatives market pegged to Libor, most of which are not loans.
"The vast majority is the notional amount of derivatives pegged to Libor," McBride says.
The term notional value denotes the value of the assets underlying the derivatives being traded. It's all very complicated, but with hundreds of trillions of dollars involved, movements of a single basis point in the index could be pricey.
Bond investors could also have been impacted.
When bonds are issued, "they look at the spreads between basic indexes. And Libor is one of those and always has been," says Robert Barone, partner, economist and portfolio manager at Universal Value Advisors in Reno, Nev.
Libor monkey business could have hit outstanding bonds as well.
"If Libor were understated, that could decrease the coupon payments investors receive, but (it) could actually have led to a higher value on the bonds they're holding, as bond prices rise when interest rates fall," McBride says.
In general, lower interest rates benefit riskier assets while higher interest rates "are a drag on the performance of riskier investments," he says.
The ongoing banking saga
At this point, it’s a lot of speculation. According to McBride, it would take several banks bidding on the same side of the equation to push Libor either way.
According to a story on the BBC website, "Libor scandal: Who might have lost?" it's not entirely clear that rate manipulations ever succeeded, "but a statement of facts published by the U.S. Department of Justice goes further in suggesting 'the manipulation of the submissions affected the fixed rate on some occasions,'" the story reports.
For more information, see: http://online.wsj.com/public/resources/documents/Barclays_statement_of_facts.pdf
While it's still unclear who lost what in the Libor-fixing machinations, the scandal does mar the credibility of financial-market participants and further underscores the need for regulation.
"It's just another nail in the coffin of how much confidence people have in these large financial institutions," Barone says.
"This isn't the last (scandal). They wouldn't happen if there wasn't the backstop of too big too fail," he says.
What do you think?
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