Posted on 31st Jul 2012 @ 12:08 PM

Asset managers are trying to figure out whether their portfolios were helped or harmed by alleged bank manipulation of the London Interbank Offered Rate, the widely used benchmark to which an estimated $360 trillion in securities of all types are pegged. Possibly in some cases, portfolio managers effectively hedged against movements in the Libor, and therefore sustained no substantial financial damage as a result of global banks' allegedly manipulating the rate downward. As the scandal has ballooned, so too have questions about its true effects on investments all over the world.

Recent revelations about the Libor scandal -- which allegedly was ongoing between 2007 and 2011 -- touched off investigations by regulators in the United Kingdom and in the United States into European and American banks' alleged roles in manipulating interest rates for their own cash gains, or to ward off the impression that they had been weakened by the global financial crisis.

In 2011, some 30 private and public investment funds filed suit against U.S. and U.K. banks that participate in setting the Libor -- which is owned and administered by the British Bankers Association -- seeking damages for reduced securities payouts on Libor-pegged investments. Some suits claim that funds were hurt by low payouts on floating rate bonds or auction rate securities that resulted when the benchmark interest rates were artificially depressed. Other funds are looking back at their investment returns to determine whether they sustained any damage. Many of the funds undoubtedly will wait to see what happens with those lawsuits, most of which are pending in the federal district court for the Southern District of New York.

Reuters news agency reported July 17 that the chief investment officer of Calpers, the giant California public employee retirement system that oversees almost $237 billion in assets, had said a day earlier that the fund was still reviewing the impact of the alleged Libor rate manipulations and that "we'll make a judgment as to whether to seek damages."

No reasons, causes -- or even motives -- for the alleged manipulation have been established; nor is it clear how, if at all, the banks may have gained (or lost) as a result. But Federal Reserve Chairman Ben Bernanke testified to Congress that "information the Fed received was about the banks possibly submitting low rates in order to avoid appearing weak during the period of the crisis." A lawsuit against 8 financial institutions filed by the City of Baltimore alleges that the banks "held significant financial positions in LIBOR-Based Derivatives, such as in exchange-traded futures contracts and in over-the-counter Interest Rate Swaps, providing them incentives to suppress LIBOR."

A complaint filed by Charles Schwab & Company alleges that financial institutions reported borrowing costs to the BBA that were lower than their "true costs of borrowing," referring to the actual interest rates those banks paid on funds they borrowed from other financial institutions. "The BBA then relied on the false information the Defendants provided to set LIBOR, a benchmark set of interest rates used to price trillions of dollars' worth of financial instruments worldwide," the complaint states. Schwab filed the suit against 38 entities, including 8 European banks and some of their subsidiaries, and four U.S. banks and some of their subsidiaries, past incarnations -- entities that existed before mergers occurred -- as well as banks' broker-dealer arms. While there are three Japanese banks that now participate on the Libor U.S. dollar panel (see box, below), they are not named in the suit.

Barclay Settlement and U.S. Response

Federal Reserve Board Chairman Ben Bernanke cited two press reports on the potential rate-rigging, one in The Wall Street Journal and another in The Financial Times in 2008, but the scandal mostly remained well clear of the headlines until recently. When Barclay Bank in London on June 27 announced a settlement with the British financial regulator, the Financial Services Authority, in exchange for a £59.5 million fine for "misconduct relating to the [LIBOR] and the Euro Interbank Offered Rate (EURIBOR)," according to an FSA press release , many more investors, money managers and regulators began to take notice.

Since then, U.S. regulators have begun looking into the matter and Congress has started to inquire. During one of Fed Chairman Bernanke's regular monetary policy statement to Congress July 17, he faced questioning by Senate Committee on Banking and Urban Affairs Chairman Tim Johnson, D-S.D. , who asked, "What did you know, when did you know and what did you do about it?"

Libor 'Structurally Flawed,' Says Fed

Bernanke responded, "Libor is a critical benchmark for many financial contracts so the actions of traders and banks that have been disclosed are not only very troubling in themselves but they have the effect of undermining public confidence in financial markets."

The BBA sets the Libor rate each day at 11:10 a.m. London time by assimilating reports it receives from a handful of member banks (see box, below), which report their estimated cost of borrowing. After throwing out the upper and lower outliers, the BBA averages the remaining estimates and reports the results to Thomson Reuters for publication. Bernanke asserted that the "issue was made complicated during the crisis by the fact that there were very few transactions occurring other than overnight [loans between banks], so banks were asked to report what they would pay if they were borrowing for a certain term." But transactions may not have been taking place under the terms for which the banks were submitting estimates, Bernanke observed. "It's clear that beyond these disclosures, that the Libor system is structurally flawed and part of the response was to address those flaws," he said.

Banks Currently Participating on Libor U.S. dollar panel

Source: British Bankers Association

Perspective: Municipal Bond Market and Libor

Funds that invest in municipal bonds -- and, in the case of the City of Baltimore, the municipalities that issue them -- may have sustained provable losses as a result of alleged Libor manipulation, according to the complaints they filed in court. The City of Baltimore suit names British and U.S. banks that comprised the U.S. Dollar Libor panel before February 2011, according to the complaint. (The website of the BBA currently lists 18 banks as the U.S. Dollar LIBOR Panel.)

But David Mack, president of Compliance Matters LLC in New York, expressed concern over what the Libor scandal is revealing about the bond market itself. "Certain municipal governments," he said, "are delinquent in the payment of municipal bond interest and appear to be walking away or reluctant to increase taxes to honor the 'general obligation' feature of these bonds and use their taxing power to raise funds to assure investors that the financial obligations will be met."

Before the introduction of bond insurance, Mack pointed out, a municipality's taxation authority was a linchpin of the bond market because it guaranteed the payment of principal and interest on the bonds they issued. "Has that principle flown out the window, along with an honest calculation of the LIBOR rate, which banks seem to have forgotten how to calculate?" he asks. "I am amazed that the concept of the 'general obligation' bond is nowhere to be seen or heard in the municipal bond business." He said, "it appears that that responsibility was passed on to the municipal bond insurance companies, who themselves are struggling to maintain their assurance as to the repayment of principal and interest."

Municipal bond issuers commonly hedge the variable-rate exposure on their bonds using swaps tied to Libor. In such a contract, the counterparty to the swap is often a bank. The bank will accept a commitment from a bond issuer for payments of a fixed rate on a notional amount, over the agreed time frame of the swap. No notional amount is exchanged -- only cash flow calculated on the rates that were swapped. The bond issuer, in turn, expects to receive cash flow based on a variable rate pegged to Libor. Regardless of allegations of manipulation, there is inherent downside risk for the bond issuer in this kind of contract. If Libor is higher than the required interest payments to bondholders, the issuer has extra cash flow that comes from the swap. On the other hand, if Libor sinks below the rate the issuer is paying bondholders, the issuer is down and must find the funds elsewhere in order to make the bond payments it legally owes. At least one municipal bond issuer, the City of Baltimore, claims that because the banks that set the U.S. dollar-denominated Libor artificially understated their anticipated borrowing costs, the city's cash flow from swap contracts to which the city was a party was lower than it should have been had there been no intentional manipulation. One conundrum the Libor allegations present is that the claims for damage as a result of alleged downward manipulation of Libor are hard to calculate, to say nothing about whether a claimant benefitted from the same artificially low Libor in other contexts. The same statement could be applied to private funds that invest in municipal bonds and use hedging strategies.

By Daniel J. Macy, Editor. This article was first published in the Money Manager's Compliance Guide (Thompson Publishing Group).

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