I’m always on the lookout for new risks to Alliance’s business. Usually, they’re deal-specific, but recently I’ve been looking at something bigger. An important piece of the financial world is changing, and there may be a bumpy road ahead for the world economy.
The London Interbank Offering Rate (LIBOR) is an average of the interest rates at which banks report they can borrow from each other for short periods. Sometimes described as the world’s most important number, it is used as a reference for adjustable interest rate contracts, like real estate loans. Hundreds of trillions of dollars of financial contracts are tied to LIBOR, perhaps including your mortgage.
Why the concern? LIBOR will cease to exist at the end of 2021, and many of today’s LIBOR-based contracts will still be valid in 4 years. If there is any sloppy language in those contracts, then disputes over the proper reference rate could be worth a lot of money, producing serious legal combat.
First, a little background: Variable interest rate loans typically pay a certain number of basis points above the reference rate (LIBOR, for now), which itself rises and falls with the market. At some point, Wall Street bankers realized that they could profit by manipulating the reference rates. And for banks with tens of billions of dollars of exposure to financial contracts, even a tiny change in rates could result in millions of dollars of quick profit.
This is fraud, plain and simple. A major bank CEO had to resign and a trader went to prison. I have no sympathy for cheaters, and perhaps the scandal should have claimed a few more heads. Still, this market manipulation was way too easy, especially considering the outsized rewards.
In the US, we seem likely to replace LIBOR with a new index, called the Broad Treasury Financing Rate (BTFR) which will rely on data from real financial transactions, rather than self-reporting by banks. Since many long-term financial contracts will still reference LIBOR even after it’s gone, we’re all facing a period of instability during the transition.
As a businessman, I like predictability, and I’m expecting the US government to step in. By setting ground rules for how LIBOR replacement should go, government authority can prevent a lot of wasteful legal fighting.
Fortunately for Alliance, we have identified only one financing contract in our portfolio that is LIBOR tied, and that contracts does not extend past 2021.
I’ll be keeping a close eye on any new developments in the LIBOR story. This change is putting us on the path to a fairer and more stable financial system. Unfortunately, the road to that future could get a little bumpy.