The Rate the Banks Once Rigged Is Jumping—and Causing Trouble
They’re calling it “Libor’s Revenge.” After years of drifting close to zero, the London interbank offered rate, a measure of what banks pay to borrow short-term from one another, has suddenly jumped. For three-month debt, it’s risen to 2.29 percent, the highest level since 2008.
Libor was made famous—Wall Street-famous, anyway—after the financial crisis, when European and U.S. banks were found to have been rigging the reported rate in ways that benefited their trading bets. Since then, a new organization has taken over calculating the rate, and regulators and bankers have been trying to phase Libor out. But its proved stubbornly hard to replace, and it still has consequences in the wider economy and markets.
About $350 trillion worth of assets are pegged to Libor. It’s the interest rate used as baseline for many bonds, business loans, and mortgages. “Libor is still the most important reference rate,” says Christoph Rieger, head of fixed-rate strategy at Commerzbank AG in Frankfurt. So the rise “makes a huge difference. This all can be very painful.”
For homeowners with adjustable mortgages, the Libor upswing may mean higher payments. Higher Libor could also create a double whammy as it causes companies’ borrowing costs to increase and lowers the discounted value of their future earnings. It can drive stock prices lower and send money fleeing mutual funds and into safer assets. That’s a spiral that can cause headwinds for the wider economy, according to strategists at Citigroup Inc. who coined the term “Libor’s Revenge” in a note published on March 18. At the very least, Libor’s lurch upward amounts to a further tightening of financial conditions at a time when the Federal Reserve is already raising its own benchmark rate.
The Fed’s moves don’t entirely explain the rise. The so called Libor-OIS spread, which measures Libor against a market gauge of the Fed’s key rate, has also hit the highest level since since 2009. That evokes some uncomfortable memories: Heading into the financial crisis, the spread surged and banks were suddenly paying a big premium to borrow. That proved to be the canary in the coal mine, signaling worries that some financial institutions were in serious financial trouble.
This time, the explanations for what’s happening are more benign. For one thing, in 2008 the spread got a whole lot wider. And today’s spread seems largely to stem from other changes in the bond market. The U.S. government has deluged the market with Treasury bills, which have crowded out commercial paper—the IOUs some companies use to meet their short-term cash needs. To entice investors to buy those debts, companies selling commercial paper have to offer higher rates. Those higher rates ultimately feed into Libor. Because of a dearth of interbank transactions, banks increasingly use commercial paper rates to guide their submissions to the survey used to calculate Libor, says Rieger.
At the same time, the Trump administration’s tax reform is spurring some big, cash-rich companies to repatriate their foreign earnings. As these companies liquidate their overseas cash piles, many want to be able to use the money right away, whether for stock buybacks, dividends, or further investment in the business. That means they may want to hold less of their cash in commercial paper with relatively long maturities, including the three-month debt that affects Libor rates.
Perhaps the biggest question associated with the recent rise in Libor is why it still has any impact at all, given its tainted history. In the U.K., the Financial Conduct Authority has said that it will stop requiring banks to provide quotes for the various Libor rates by the end of 2021. In the U.S., a committee has decided to base a new rate on the cost of overnight loans, called repurchase agreements, that use U.S. government debt as collateral.
But the transition is likely to be a long and winding one, not least because it ostensibly involves altering millions of legal contracts tied to an increasingly outmoded rate. “It doesn’t matter that they want to get rid of Libor,” says Peter Boockvar, chief investment officer at Bleakley Financial Group LLC. “Trillions of dollars of global loans are still priced off it, including about one-third of all U.S. business debt.”
Still, there are some winners in the turmoil this year. Chris Sullivan, chief investment officer at the United Nations Federal Credit Union, says he’s been loading up on adjustable-rate securities that profit from Libor’s rise. And he sees no credit event brewing, since U.S. banks have ample capital buffers. “We have been buying all kinds of floating-rate instruments tied to Libor, which has been a pretty favorable thing to do,” says Sullivan. “Perhaps we haven’t considered seriously enough what that could mean in the future, when Libor is replaced. But the future in my mind is still some years away.”
For those who haven’t been benefiting from higher Libor, there may be a glimmer of hope. In the days after the Federal Reserve made a widely expected move to raise benchmark interest rates, Libor and its spread over OIS have expanded only marginally.
For now, the beleaguered benchmark remains the only game in town. “Everybody wants Libor to go away,” says Jim Bianco, president of Chicago-based Bianco Research. “But nobody has a better alternative to really use for now. So here we are.”