Libor: Are There Any Winners?

You didn’t really think that supporters of the global banking industry would simply surrender to public condemnation regarding the Libor manipulation scandal … did you?

Two weeks ago, we described why the scandal posed a threat to the public interest. And last week, we discussed the difficulties that plaintiffs may face when filing lawsuits to recover their losses.

This week, we end our first-ever trilogy of blog columns by exploring a recent counter-argument that is gaining traction among supporters of the global banks. Namely, some industry veterans are asserting that the scandal did little to harm borrowers …

… and may have actually helped them!

Interest Payments

The essence of their argument appears to focus on the direction in which the bankers at Barclay’s appear to have manipulated the Libor interest rate. Namely, they appear to have understated their rate quotes, as other banks purportedly did as well during the depths of the financial crisis in order to maintain the impression that they were strong and stable institutions.

The Washington Post recently quoted several industry experts who asserted that, by understating interest rates, the banks actually assisted borrowers by minimizing their interest payments. And Bloomberg quoted a representative of British mortgage lenders who claimed that “it’s very unlikely that Libor-fixing will have had any material impact at all on consumers … if anything, a downward impact on Libor (was) advantageous overall to the wider influence on rates …”

From a narrow perspective, this argument is indeed true. Borrowers with fixed rate loans, for instance, would not be affected at all by Libor rate manipulations. And borrowers with variable Libor-based loans would indeed enjoy reduced payments when the rate is manipulated downwards.

But from a broader perspective, would these conclusions remain valid?

Interest Rate Swaps

Let’s consider an example of a debt arrangement that is far more complex than a single variable rate residential home mortgage. Let’s ponder the plight of a municipal government entity, for instance, that agrees to a primary fixed rate debt instrument with a secondary variable interest rate swap.

Huh? How would such a transaction work?

Well, the borrower would pay a fixed interest rate on its primary debt outstanding, and then would purchase an exotic secondary derivative that would provide varying levels of reimbursement in proportion to fluctuations in market interest rates. The two opposing cash flows, when netted together, would be designed to generate net interest payments that would reflect changes in the variable Libor rate.

Unfortunately, though, this strategy backfired for many government borrowers (as well as for investors in debt instruments) when Libor rates declined, purportedly as a result of understatement manipulations. Such declines minimized the variable cash inflows received on the derivative transactions, but did not affect the cash outflows paid on the primary fixed rate obligations. That is why the City of Baltimore, the New Britain Firefighters’ and Police Benefit Fund, the California Public Employees Retirement System, and others are now contemplating legal actions.

Macro-Economics

There is also a macro-economic perspective that should be considered when assessing whether any borrowers have benefitted from the Libor scandal. To consider this perspective, let’s assume that the global banks were indeed fixing variable rates at inappropriately low levels.

Because other lenders “peg” their variable rate loans to Libor as well, they would have also received lower interest payments from borrowers. In other words, the revenue streams of relatively small competitors would have been damaged as severely as those of the global banks by such manipulations.

But which institutions may have benefited from revenue declines that affected global banks and smaller competitors simultaneously? The global banks, by nature of their sheer market size, their implicit (or explicit) access to bailout programs like TARP, and their thicker capital cushions, undoubtedly would have been better positioned to survive such circumstances.

In other words, like any dominant industry player that launches a price war with the intention of driving smaller competitors out of business, the global banks may have enjoyed a macro-economic advantage by forcing market interest rates lower. In the long run, the elimination of competition cannot be beneficial for consumers.

The Public Trust

There is one final perspective, perhaps the broadest one of all, to consider when assessing whether any borrowers actually benefitted from the Libor manipulations. Namely, can any member of society ever benefit, in the long term, from scandals that fundamentally damage the public trust in our global financial system?

If public cynicism about the system permanently depresses demand for variable rate loans in the United States, for instance, can any one truly benefit? Likewise, if citizens in Greece and other struggling European nations rebel in disgust against the austerity measures that are needed to repay the government debts held by global banks, can the system ever heal?

In the broadest sense, it is difficult to argue that any deceitful manipulation scheme can create “winners” among borrowers. In the long run, if there is no public trust in the global financial system, we are all inevitably “losers.”