What if LIBOR is disrupted? Something new to worry about, as if Europe’s slow motion financial train wreck, the U.S. elections, the fiscal cliff, the slowing U.S. economy, Mid-east tensions and uncertainty about the Asian economy aren’t enough. We now have a broken LIBOR to entertain us too!

Here’s the state of play. LIBOR, the London Interbank Offered Rate, is set by the British Banking Association (“BBA”).  Like Ivory soap, it is a branded and trademarked product.  While it seems like it’s been with us forever, its origins date only back to 1986.  LIBOR is an adjusted average of the rate a pool of contributing banks concludes would be its borrowing cost that day.  Thomson Reuters is the calculating agent.  The banks involved in the survey are picked by the Foreign Exchange and Money Markets Committee of the BBA, based on the scale of market activity, credit rating, and perceived expertise in the relevant currency.  The calculating agent throws out the highs and lows and, through an algorithm, comes up with a “Rate” that is published as LIBOR.  As everyone knows by now, the heart of the current controversy is that the contributing banks don’t provide actual market rates, but merely estimates of the rate at which the institution could borrow funds in the market.

Putting all the current Sturm und Drang aside, what actually could happen if LIBOR were disrupted?  There’s something like $800 trillion of financial assets outstanding that are priced at a spread to LIBOR.  While it seems pretty unlikely at this point that we will wake up one morning to find that LIBOR is not published, that doesn’t mean there are not issues (and if enough banks balk at providing quotes quickly and before the BBA has Plan B in place, we indeed could wake up without LIBOR one morning!).  What we may find, however, is that the composition of the reporting banks is vastly different, the BBA rules on how rates are reported are different and that a broad consensus begins to develop that LIBOR just should not be the pricing reference rate for trillions of dollars of financial assets any longer.  There may be some market participants simply not willing to accept pricing off LIBOR.

So, what to do?  First, there is always the option to pursue a strategy of hope; hope that LIBOR will, in fact, not be disrupted and that this will blow over.  On balance, this might turn out not to be a bad strategy.  But, then again, it might go wrong.  With a bow to the fact that Black Swan events seem astonishingly common these days, it might be prudent to ask (and perhaps answer) some key questions:

  • Which financial asset to which we are a party is LIBOR priced? Are there alternate rates specified in the documentation if LIBOR is not published?  Many financial documents contain such baked-in alternative basis language.  An example:
    • Where the “USD-LIBOR-BBA” rate is used to determine value, the rate is determined by the Reuters Screen LIBOR01. If LIBOR isn’t available, the value will be determined using the “USD-LIBOR-Reference Banks” rate. To determine this rate, the Calculation Agent requests quotes from the London office of each Reference Bank. Where two or more Reference Banks respond, the rate will be calculated as the arithmetic mean of the responses. Where less than two respond, the arithmetic mean of the rates quoted by “major banks in New York City” will be used.
    • Do note, unascertainability means more than “We just don’t like it anymore.”  Query can one make an argument that if the LIBOR formula is radically changed by the BBA, it’s not LIBOR?  Certainly not clear.
  • Should we continue to price financial instruments off LIBOR on a going-forward basis or look for an alternative?  There is some talk that the newish U.S. repo futures market could provide a benchmark to compete with or replace LIBOR.  It does have the benefit of being based on actual rates.
  • Should we bake in an alternative rate in every LIBOR-based financial asset going forward?
  • Consider asking existing counterparties to agree on substitution of a new index rate now or add an alternative rate, as opposed to waiting for possible disruption later.
  • What is the litigation profile?  The alleged problems with LIBOR over the past several years could be both a sword and a shield, depending on where one sits in a particular transaction.  There has been considerable speculation in the media about LIBOR-based litigation.
  • What about securities disclosures and financial reporting around LIBOR-indexed assets?  I can almost guarantee that we will see securitization risk factors around LIBOR in the coming months. Here are two examples:
    • The Floating Rate and Inverse Floating Rate Classes will bear interest at interest rates based on LIBOR established on the basis of the “BBA Method”.  No assurance can be given that LIBOR for a Distribution Date accurately represents the London interbank rate or the rate applicable to actual loans in U.S. dollars for a one-month period between leading European banks, or that the manner in which the interest settlement rate of the BBA for one-month U.S. dollar deposits is calculated will not change. Nor can there be any assurance that LIBOR’s prominence as a benchmark interest rate will not diminish; or
    • Recent information has called into question the integrity of the process for determining LIBOR, and the full implications of such information are unknown at this time.  While the Issuer’s assets and liabilities are naturally hedged as the substantial majority of the interest payments due on the Issuer’s assets are expected to be calculated based upon LIBOR and the Secured Notes pay interest based upon LIBOR, an inaccurate LIBOR setting could have adverse effects on the Issuer and/or the holders of the Secured Notes.  For example, holders of the Secured Notes would receive lower dollar amounts as interest payments if LIBOR was artificially lower than a properly functioning market would otherwise set LIBOR.  Other negative consequences of the perceived inaccuracy of LIBOR could include fewer loans utilizing LIBOR as an index for interest payments and/or erratic swings in LIBOR, both of which could result in interest rate mismatches between the Issuer’s assets and its liabilities and expose the Issuer to cash shortfalls.  Furthermore, questions surrounding the integrity in the process for determining LIBOR may have other unforeseen consequences, including potential litigation against banks and/or obligors on loans, which could result in a material and adverse effect on the Issuer or the holders of the Offered Securities.  Investors should consider these recent developments when making their investment decision with respect to the Offered Securities.

There’s probably more to do, and as we spend more time thinking around LIBOR disruption, I’m sure the list will lengthen.  But for right now, consider using the calm before the potential storm to start to think about the unthinkable.  It’s on our plate.  We can’t wish it away.

By: Rick Jones