The revelation this summer that the London Inter Bank Overnight Rate (LIBOR) has been the subject of manipulation sent shockwaves around the globe. If that rate—one of the cornerstones of the banking system—is being gamed, is there anything that we can trust?
For the commercial real estate industry, LIBOR comes into play primarily for two kinds of loans: construction financing and short-term floating-rate bridge loans. Both products are priced at a spread to LIBOR.
But it’s impossible to say who has benefited and who was burned by the manipulation of LIBOR. For now, all we know is that Barclays has admitted to gaming the rate. Other banks are still being investigated. But Barclays reported higher LIBOR rates prior to the 2008 financial crisis and then lower ones after. That means borrowers, depending on when they got their loans, may have been either hurt or helped. The same is true for smaller banks that used LIBOR as the base on which they originated loans.
Still, a major disruption to or discontinuation of LIBOR would directly affect those areas of finance that govern real estate lending as well as contribute additional uncertainty to capital markets that still haven’t fully recovered from 2008.
The worst case scenario is LIBOR being dumped entirely. That would require loans based on LIBOR to use an alternative index. Such a change would affect existing and future loans. Most loans are structured with language that would allow the replacement of LIBOR with an alternative index. But there is little agreement as to what would be the obvious replacement for LIBOR.
Fortunately, this scenario seems unlikely.
Since the initial shock, the lending business has returned to normal. Borrowers are still receiving loans based on LIBOR. And there has been little disruption to the volume of construction and bridge loans being originated.
There has been some talk of making the way LIBOR is determined more transparent. This would certainly be welcome and leave the system less prone to manipulation. And it would not require moving to some other index off which to price floating rate debt.
So for now, the situation serves mostly as a warning to the sector rather than a true disruption.
Still, there are some causes for concern. For one thing, it is just the latest in a series of shocks to the finance system that continue to shake confidence in capital markets. Despite many improvements since the 2008 financial crisis, the system is still functioning at just a portion of the capacity it once had. And incidents like this just delay the recovery even further.
Secondly, the incident increases the potential for regulatory changes that would create further disruptions. So far, only Barclay’s has admitted to manipulating LIBOR. But investigations continue into other banks as do discussions of potential settlements with both U.S. and European oversight bodies. As details come out, the pressure for regulation could rise.
For example, in Britain there is real discussion of re-instituting rules mandating the separation of commercial banks and investment banks.
That conversation has not leapt across the Atlantic to enter the United States yet. But such a change—reinstituting something akin to the Depression-era Glass Steagall Act that was repealed in the late 1990s—would be a massive change to the financial system that could have loads of unintended consequences.
Thus, more than anything, what the LIBOR scandal should trigger is some caution for the sector. And it should have borrowers and investors contemplating the dangers of big changes to the financial sector if the scandal continues to blossom.
For now, it’s business as usual. But contingency planning would be an excellent idea.
Contact Editorial Director David Bodamer at [email protected].