On Internal Indexes, like LIBOR

When I was a life actuary, following the deferred annuity market, the concept of market-value-adjusted annuities arose.  Annuity values could react like bonds to:

  • An external index rate, or,
  • An internal index, driven off of the new money rate for annuities

Now, the internal index sounds soft, but it is not so.  Yes, you can lower your new money rate but reserves grow on indexed products.  You can raise your rates, but reserves will shrink.  It’s not perfect here, but the internal index will work over the long haul.

So when I look at LIBOR and potential manipulation, I don’t see a lot of reason for concern.

When bond deals are priced, the relative yield is what is priced; it does not matter what the benchmark is, roughly the same overall yield would have been obtained.  Spreads are a way of expressing the excess yield over equivalent maturity government or AA bank (swap/LIBOR) yields.  They are a result of the process, not a driver of the process.

If 3-month LIBOR were replaced by the on-the-run 3-month Treasury yield, new deals would be priced, and the spreads would be higher by the TED (EuroDollar – Treasury) yield spread.

When I was a bond manager, dealer desks would often try to sell or buy bonds off of unusual benchmarks.  I would always make the necessary adjustments to calculate the option adjusted spread over interpolated swap rates, with further adjustments for the degree of premium or discount to par.  (Note: A premium bond carries extra credit risk because if it defaults, the most you can recover is par.  Opposite for discount bonds.  There is a mathematical method for calculating the amount of yield tradeoff between premium/par/discount bonds, even in the absence of a credit default swap [CDS] market.  You assume that the spread over swap is the CDS premium, and calculate the annual cost of insuring the premium to par.  Deduct that from the current spread, and you have the hypothetical true par spread.  Once you have that, you can make rational swap trades.)

What I am trying to say is that benchmarks/indexes aren’t all powerful.  Bright bond investors look past them, and analyze the economics of the situation.  Same for intelligent borrowers; they know that LIBOR rises during times of financial stress.  If you are a floating rate investor/borrower, you ought to analyze the rate that your investment/loan is tied to.

Many commentators with knowledge of the situation think that lawsuits regarding LIBOR will amount to little (one, two).  Yes, there may have been some manipulation in a micro-sense for some banks, but in terms of having a big effect on many, I don’t think that is possible.  There might be some degree to which borrowers benefited and savers/lenders lost.  That’s a tough case to press on any side.  Courts favor borrowers, and they benefited from any manipulation.

In closing, I don’t think much will come from the “LIBOR scandal” the same way that nothing will come from the “rating agencies scandal.” Both are examples of summarizing information/opinions that investors can use at their own risk.  They are not fiduciaries; those who use the information do so at their own risk.


  • Doug says:

    David, I respectfully disagree. Given the assymetry of the lawsuits, I cannot help but think that the large banks are facing serious consequences. That is, every party to a swap that receives LIBOR has been underpaid, and will sue for damages. But the swap counterparties who paid LIBOR and were overpaid will effectively be immune, since it was the BANK that mis-stated LIBOR in the first place. If you deliberately underprice an asset and sell it to me, you can’t very well turn around and sue me after the fact to recover the “fair price” of the asset that you deliberately mispriced!

    The banks all had systemic motivation to understate LIBOR. Trillions of notional value in swaps were mispriced. The value of one basis point for one quarter on one Trillion dollars is $25 million. If LIBOR was understated by 10 bps for 1 year on $10 trillion, that’s $10 billion–a whale-sized loss.

    This may not be enough to wipe out a large bank’s capital, but it isn’t a nonevent, either. It seems that the losses, although not likely to cause systemic risk, could put some share buyback and dividend payment plans at risk, especially in the light of Basel 3 capital requirements.

  • Conscience of a Conservative says:

    Disagree here as well. Your argument would only make sense if the investor was libor based and their cost of funds matched the pricing discrepancy of the reporting or if the investor was fully cognizant of the pricing error(We see all too often information is asymmetric in the financial community). I would also suggest you are not looking at the big picture here at what instruments are libor based. It’s not just bond deals or mortgage backed issuance but of derivative contracts. What the banks did represented fraud and collusion and affected the payments of trillions of dollars of derivatives and the mark to market of those positions as well. That this is not being treated as criminal(it’s only fraud and collusion, right?) tells us that finance operates outside our established system of rule of law.

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