Interest rate swaps: the accounting aftermath

Business managers and their advisers are wrestling with the financial fallout from interest rate hedging products offered by their banks that went wrong.

After the Financial Services Authority (FSA) recently criticised leading banks after finding that some 28,000 businesses were sold inappropriate interest rate hedges. 

In a statement to the market the FSA added that the products had had a “severe impact” on some small businesses and that it expected banks to provide appropriate redress. The banks have now agreed to compensate small and medium sized businesses mis-sold the products, but accountants have been assessing the impact of the scandal, and how affected companies should go about making a claim.

AccountingWEB member jstuckey posted on Any Answers about a client who claimed to have been scammed into taking an interest rate swap by one of the banks.

The arrangement left the balance sheet looking insolvent, which raised the question of how to refer to the interest rate liability under the going concern note.

Have you been affected by the rate swap scandal, and how do you record any consequences in the company accounts?

Continued...

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Comments

Additional wrinkle ....

JC | | Permalink

'.. Typically, payments made by one counterparty are based on a floating rate of interest, such as the London Inter Bank Offered Rate (LIBOR) ..'

'.. Swap Rate can be calculated by using the 6-month LIBOR “futures” rate to estimate the present value of the floating component payments ..'

It would seem as though these contracts may have been affected by the LIBOR scenario

In fact if LIBOR were 'fixed' to stay low then that would indeed have adversly affected the holders of these instruments (derivatives) who would potentially have lost out - most of these contracts were to hedge against interest rate rises & had a penal downside

Just gets better & better .....

Ideally they need to apply to the courts to have all these contracts set aside

listerramjet's picture

caveat emptor anyone?

listerramjet | | Permalink

“Having said that, many businesses undeniably relied in good faith upon the bank's advice if not out and out pressure to take these products.” 

I would love a mailing list of those who gave in! 

But there is a precedent for setting the contracts aside - the payment protection insurance misselling fiasco.  The courts might no be so forgiving of the business community, but the FSA does not seem to have such scruples.

ksagroup's picture

A Solicitor?

ksagroup | | Permalink

We know the solicitor who is spearheading the campaign on this misselling issue.  Ali Akram of Lex Law

 

http://lexlaw.co.uk/interest-rate-swap-mis-selling-solicitors-hedging-lawyers.php

 

Royale ...

mikewhit | | Permalink

So, not content with 'casino-ing' their own money, the banks seem to want their customers to casino their money away on swaps and the like as well ...

I would suggest that it should not be allowed for a 'normal' bank employee to sell these deals, it should have to be handled by a visibly separate team, just to emphasise the different risks the borrower is exposed to.

Did I hear someone say "croupier" ?!

Lawyers dealing with mis selling

yitz jaffe | | Permalink

 

There are various to be found on the web. Alison Loveday has been on BBC and SKY - I

am working with www.berg.co.uk to help clients, some of whom have found it necessary

to sell their homes to fund the demands from the banks.

 

 

Libor and swaps

indiajack | | Permalink

Generally retail banking staff are clueless about the details that affect interest rates swaps. In fact most of them do not know what the difference between simple interest and AER is.

Without knowing more details it is difficult to comment further.

However, there was no Libor fixing. the FSA has made a mistake. Analysing the FSA report that imposed the fine, there is no evidence of Libor rigging. The FSA personnel have not understood their market. The e-mails are banter,comments and opinions.

The fine was accepted because Barclays did break principle 2.5 by stating the incorrect cost at which it borrows money from other banks for 12-months and if pedantic, Principle 3 was also broken because they did not have any formal control for Libor submissions. in my opinion, it was not and still is not necessary because it is very difficult for Libor to be manipulated.

Libor is fixed on the submissions of 16 banks, the highest and lowest 25% are discarded. So significant sized manipulation will be discarded. Then the average of the remaining 8 is calculated for Libor fixing. So if as the FSA claims are around 0.5 to 3 basis points, the averaging will make this negligible in the impacv delivered.

For simplicity let us say that Barclays got into the 8 amd manipulated it submission by 1 basis point or 0.01%, The effect on averaging is 1/8th of a basis point or 0.00125%. Applying this to £1 billion for a year, increases returns by £12,500. For a day, this about £35. Why would anyone bother?This is too low.

An interest rate swap is calcuted using the zero-rated forward yield curve. A 2-year fixed against 3-month is computed by calculating each forward-forward 3-month segment with the two year horizon at the time of contracting, i.e. 8 3-month segments, => the 1st 3 months now, the next 3 months in 3months time now, the next  monthsin six months time now, etc. When these cash flows are worked out, the rate at which these cash flows cane be discounted to give zero net present value is the 2-year swap rate.

If someone wants to break after the firs 6 months, the bank will have to place and equal and opposite swap for 1.5 years to cover it cash flows. If rates are higher, it will have to pay more and charge the break, if less the bank will have to pay less and give the difference to the customer breaking.

 

 

 

casino banks

indiajack | | Permalink

There are no casino banks in the UK, The regulations make it very expensive for them such that the profits are minimal and insignificant.

Casino trades are carried out by hedge funds and pension funds, who are not subject to these regulations.

The crisis was caused by people and governments borrowing too much.

Disagree ….

JC | | Permalink

@indiajack

The thrust of your thread seems to be that it is questionable whether the LIBOR rate could be influenced and even if they did manage anything the figures would be so low that the impact would be negligible

Would have to disagree about your interpretation that no LIBOR fixing took place on the following basis

  • Traders & banks have already admitted (for whatever reason) submitting incorrect data that may have affected the rate
  • Barclays has so far been the only bank actually in the firing line and until we know more about the other banks it is difficult to form a definitive opinion. However, to all accounts it does look as though Barclays were not the only bank doing this and were simply one of many banks submitting adjusted data
  • A lot depends upon how many other bank members of the 16 also submitted incorrect data and the nature/magnitude of the fix they submitted.
  • Clearly if one intends to submit incorrect data one wants it to be included in the middle 50% (after topping & tailing by 25%). Therefore any adjustment will be geared to fit this profile to influence the LIBOR rate; these guys are not stupid and recognise that a fraction of a point could be all that it takes
  • On this basis only a single bank would be necessary to affect the final rate and once many banks participate in submitting erroneous data then the probability increases accordingly

On the subject of negligible impact, we are not just talking about the specific interest rate swap but rather a wider issue

  • Why would anyone even attempt this if there was nothing to be gained (either credibility or financial)?
  • The Forex market itself (Q4 2011) had volumes in excess of $215 billion daily & $4,777 billion monthly which makes annualised figures quoted per single billion pale into insignificance
  • Don’t forget that Forex carry trades may also have been affected indirectly - these markets operate at pip level (1000ths)
  • Decisions on which currency pairs to trade can often be made on the interest rate differentials between them
  • And so on … once one looks at the ripples created by a LIBOR fix the possibilities are limitless

Granted that the economic crisis we are in at the moment was ‘..caused by people and governments borrowing too much ..’ but that does not exonerate the banks from their part in the scenario and neither does it make the impact negligible

EDIT:

Bob Diamond was keen to get one point across before he left the parliamentary committee without saying much else - other banks have been at it too

The root of the investment banks ills is 'leverage' because as history has shown at some point it goes wrong (JP Morgan - http://www.guardian.co.uk/business/2012/jul/13/jp-morgan-doubles-reported-loss?newsfeed=true ). Although, the secret with banks is to make the killing and get out before it all hits the fan

But in reality no-one was really prepared to rein in the banks at the time because the overall pain all round (trigger recession, house buyers, government etc) would have been too great - therefore they were allowed to get away with dangerous practices

Tomorrows crisis in the making ?????

However, it now looks as though its 'game on' again (cosy up to regulator, high leverage etc..). Welcome the ECB's idea of assessing for themselves sovereign bonds and by-passing the ratings agencies. Banks are back in the game with high leverage & dodgy bonds & regulator approval (all the ingredients)

Arbitrage here we come ....let the good times roll again for the banks

Your disagreement has no viable basis

indiajack | | Permalink

Firstly, it is not an interpretation - these are facts and not opinions, except for formal controls not being required for Libor. for te rest:

 

1. The fact is that no traders or bank have admitted to fixing Libor or Euribor and this would be a criminal offence. Barclays paid the UK regulator fine because it had lied to the FSA on what it borrowed 12-month money at on December 2007 (it said that it had borrowed at Libor flat instead of Libor plus 20 basis points) and it did not have formal controls to fix Libor.

2. If there were other banks they would have already come into the firing line. there aren't any. in addition, there has already been a rigorous investigation published in Social science Research Network on 4 August 2008 concluding no Libor manipulation.

3. You are right in that there would have to be collusion for Libor to be manipulated. In addition to the investigation stated, Lior is the rate at which banks borrow from each other. It also shows where the credit contraints are when they submit. Even if the 16 banks (you actually need a minimum of 8) colluded and none reneged, the other banks would have arbitraged the imbalance because te fixing would be representative and therefore cause disequilibrium that can be taken advantage of by other banks. Furthermore, there is motivation for one of the 16 to renege - it is explained in John Nash's Prisoner's Dilemma. In any case, they did not submit high magnitude submission that were out of line. You also have to look at what the Federal reserve and te bankm of england were doing and what the economic effect was on interest rates.

4. Exactly, these guys are not stupid, they are aware of arbitrage and prosecution if they manipulate the market. They also know that a few basis points are not worth it. More importantly, if you were in that business you would know what the FSA transcripts really meant and not someone looking at it from a totally divorced perspective that is not reprtesentative. this is not teh first time te FSA has screwed up.

5. I do not agree with you analysis that reaches the conclusion ..."On this basis,..." bercause I have already shown the impact one basis point raised by one bank would be, shown that collusion is marred by the Prisoner's Dilemma and by other international banks arbitraging.

6. Why would anyone attemptthis.....  Exactly, it was not attempted! It only looked like that to the FSA. With regard to the US, the regulations are quite different in that they are prescriptive and complex, based on different legal principles (look at the extradition treaties as a very very simplistic example) , and they may in the end have been proven to be breached if Barclays lost a lengthy and expensive court battle in the US. Even if they won, te bill to Barclays would have been huge.

7. the Forex market does not run on Libor and even if it did you are assuming that everyone has an FX position that is facing the same direction. This is a must for what you propose to work. In reailty, most of the positions offset unless there is someting obviously out of balance. You figure look at the aggregate of the total number of traders that take place and not the offset exposures. your figures also incluyde central bank open market operations which would reflect government actions or reactions to economic impacts of movements in countries unrelated to trading and the sort of business involving Libor.

8. As said, FOREX (FX) does not involve Libor and these FX markets are near perfect. even in the billions, you do not look at "big figures". Otherwise it is not worth the cost of capital set aside for Value at Risk.

9. You are right that currency differentials arte based on interest rate differentials. Spot currency i not based on Libor differentials - they are based on the value of the currency of each country and therefore base rates and overnight rates, which are not Libor. FX swaps however are affected by Libor. But as said earlier, an out-of-sync Libor set will be arbitraged.

 

10. The base and central cause was people borrowing too much cause. banks facillitated this because they could repackage and sell of this credit exposure to speculators. I have been talking about banks in Europe and the UK. and not the US banks. The US banks did not adopt the risk citeria adopted in Europe and the UK and were engaging in regulatory arbitrage. The UK government did nothing to lobby the US government on this imbalance. There were attempts in the UK and Europe to rein in the banks and these risk regulations were part of them. If the US banks had also been governed by them the financial crisis would not have been a crisis.

Bob Diamond did not say too much because there was nothing much to say, especially when the Treasury Select committee lack sufficient technical knowledge. In ny case, the fine imposed was not for Libor fixing but mileading the FSA on the 12-month borrowing rate and not having formal contyrols over Libor submission. This was the breach and it is fact. the public and the journalists make their conclusions on imperfect knowledge and less than full facts. You should substitute a biased and ill-informed Guardian, with aless baised and better informed FT.

There is a financial crisis in the making. The government is asking the banks to take on more high risk by lending to SMEs, forgetting that it was over-lending that caused the crisis. Additional risk and capital regulations have increased the cost of lending to busineses. Casino banking is minimal and insignificant in the UK banks because the regulations make them expensive and unviable. The UBS and Jerome Kerviel debacles were not to do in the main with UK banks. These men were execution officers putting through trades taht their clients instructed them to but then went onto hide their own speculation within the execution of the trades.

Leverage in the UK and Europe and even in the other parts of the world barring then US is now limited by the regulations these regions have agreed to adopt and are implemented. Your information needs to cover this.

However, in my opinion, there matter of securitisation which created highly toxic assets because the maths pricing was fundamentally wrong, has not been properly addrssed and this is why there are still so mant toxic assets or rather repackage bad loans. The US is still fighting and insisting tyhere is intrinsic value to these.

All financial crisis since the Mississppi scandal of the 18th century have been the result of over-borrowing - research it, I have.

Arbitrage means riskless profits and yes, then the good times will roll. It will also mean no risk exposure and therefore no financial crisis. However, there is little scope for arbitrage these days as markets (such as FOREX) edge to perfection and liuidity is now being costed.

So I am afraid that you disagreement cannot be supported and does not stand.

 

 

 

 

 

 

 

Not quite – references required for stance on FSA etc ….

JC | | Permalink

@ indiajack

‘..However, there was no Libor fixing. the FSA has made a mistake. Analysing the FSA report that imposed the fine, there is no evidence of Libor rigging. The FSA personnel have not understood their market. The e-mails are banter,comments and opinions ..’

Could you please provide a reference/authority for this statement

http://www.fsa.gov.uk/static/pubs/final/barclays-jun12.pdf

Point 1

'Section 2: - '.. Barclays agreed to settle at an early stage of the FSA’s investigation ..'

Did the investigation run its course or was it cut short by Barclays?

Section 52-69 makes interesting reading

Section 70-71: - '.. On the majority of occasions where Barclays’ Submitters were contacted by Barclays’ Derivatives Traders with requests, Barclays’ submissions (for US dollar LIBOR and EURIBOR) were consistent with those requests ..'

Point 2 – not necessarily. Barclays ‘came clean’ (also DB had been in the spotlight before in 1998 with a Russian default) as the lesser of two evils (hobsons choice) & considerable costs. Other banks will no doubt be investigated and the future will tell, however, at this stage it is not possible to state ‘..there aren't any..’

Point 3 – disagree – only one bank would necessary to influence. Not talking about the degrees of influence but absolutes; whether things were changed by even a minute amount because of a single false submission in the right range (like binary either yes/no & nothing in between).

Of course collusion makes a greater impact but only one in the right range can make a difference. Also any other factors should be ignored ‘..they did not submit high magnitude submission that were out of line. You also have to look at what the Federal reserve and te bankm of england were doing and what the economic effect was on interest rates ..’ This is the line between right/wrong and one cannot be a little bit wrong in the same ways as you cannot be a ‘little bit pregnant’ and there is no element of Prisoner’s Dilemma

Point 4 – Of course they are aware of the penalties but perspective gets warped with the perception that ‘everyone is doing it’ – furthermore, the dynamics of risk (risk intelligence) inevitably plays a part and human beings are notoriously adept at making the wrong decisions

Point 6 – ‘..it was not attempted ..’ – have to disagree on all the available facts. If you have evidence to contrary the please publish and it can be discussed. Also ‘..may in the end have been proven to be breached if Barclays lost a lengthy and expensive court battle in the US ..’ is another reason why Barclays chose to stop the investigation by admission – quite frankly these sort of things can get totally out of hand and Barclays exercised a damage limitation policy – does not mean that they were not guilty (this is where Prisoner’s Dilemma comes in) just they managed to stop the investigation

‘..The government is asking the banks to take on more high risk by lending to SMEs, forgetting that it was over-lending that caused the crisis ..’ Yes it was over lending but this statement ignores the fact that it was predominantly ill-advised (bad) lending rather than over-lending per se that caused the problem and this was as a result of failing proper risk assessment.

Once the banks got into the loop of ‘lend/package the loan/flog it off’ then all checks and balances went out of the window and it became a matter of turnover rather than assessing borrowers risk – this is where over-lending came in; furthermore this scenario is entirely down to the banks and their creative approach to business

To turn around today and claim that ‘..The government is asking the banks to take on more high risk by lending to SMEs ..’ is specious in the extreme and belies the real situation which is that they are trying to bolster their balance sheets at public expense.

Here is an example of current lending policy - http://www.accountingweb.co.uk/anyanswers/question/example-banks-have-no-wish-lend and yes you may have guessed the bank was Barclays

‘..Arbitrage means riskless profits and yes, then the good times will roll. It will also mean no risk exposure and therefore no financial crisis ..’ – not entirely – in these circumstances doesn’t mean that there is ‘..therefore no financial crisis ..’ just that the banks have no risk exposure and instead the rest of the EU, public and taxpayers at large carry the risk.

Unfortunately over the last few years this has become the ethos of banking – any risk is mutualised over everyone but themselves. Essentially they ceased being bankers & lost sight of their primary role in preference to being salesmen  - flogging all manner of add-ons at every opportunity whether it was in the customers interests or not

I guess the upshot of this is that we will have to agree to disagree over this

definite so and not not quite

indiajack | | Permalink

Providing a reference or authority: Me, I am a technical and subject matter expert with market experience, (while the FSA is not), and have been engaged in forensic financial investigation of this nature; and have dealt with the FSA on similar matters.

On Point 1 – the accurate answer to your question is that there was an investigation but it was not carried out by people familiar with the process and environment. Barclays settled because within the Libor fixing allegation, it had committed two breaches. On one, which had nothing to do with Libor fixing, it lied at the rate at which it had borrowed 12-moth money n the past (Libor is a future fixing) and the other it did not establish formal controls for Libor submission. These two would have resulted in the fine of at least such a size if it had contested the other findings.

section 52-69 and 70-71 – what the FSA termed requests were not requests or even considered requests by the submitters. There were one or two instances of apparent acquiesance but it was in reality when put into context by someone familiar  with the environment, the two were mutually exclusive and there was never a request. You know that your e-mail and indeed your telephone conversations are recorded and reviewed randomly. So you would never engage in such. It is a criminal offence to manipulate the market.

Point 2 - I can't recall what DB did in 1998 but Barclays did not come clean as explained above. It knew it had breached FSA principles but not for Libor manipulation. Even today's allegation of Libor manipulation by Lloyds, alleged by US is inaccurate. The FSA would have checked the other banks as a matter of course and imposed fines on all. It isn the way the operate if they find one potential hole.

Point 3. You are fundamentally incorrect it takes more than one bank to influence under the current Libor process, That is what the process was designed to address and it does quite effectively. If greater comfort is required, the averaging population should be increased, while retaining the discarding proportionality and criteria. This not an opinion but an arithmetic fact.

No, collusion is the only avenue for there to be an impact because of the arithmetic safeguard. Again, not an opinion but a fact. one cannot be a little bit pregnant but one can miscarry. I have not included all the other issues as it will take me too much time and I have a job to do. But as an example on 30th Oc 2008, all banks reduced their Libor submissions considerably. But this was because the Federal Reserve dropped its interest rates considerably on the 29th  at 1630 hours. The FSA did not include this. Furthermore, Barclays reduced by the greatest but this was because it had secured a £7.3 bn investment. The Prisoner's Dilemma occurs only under collusion and there was none for it to occur.

You have to understand that at a certain level of over-lending the loan becomes bad. if you keep lending to a customer, there will be a point when what earns or is likely to earn is less than what he needs to service his debt, much less pay it back. SMEs are in accurate technical terms "high risk" but if translated to the colloquial bad lending because of the inherent riskiness. The statement does not ignore anything, it describes reality. There always was proper risk assessment in the UK. However, there were also buyers who would buy low quality credit if combined with high quality credits in a specific packaging. So the bank coul lend to both, repackage and sell the risk off. It is when the buyers demand stopped that the problems started. This was because they realised that the amount borrowed was more than what could be serviced in interest payments and repayment.

The banks have are a cause but people have more responsibility for it. They are responsible for their actions as they are not minors. As far as banks were concerned, they were not the debtors, and they were not. The checks were there but there was no need for balances as the banks were not exposed to the lending. However, because so much credit was being engineered, the interest rates which were low when the repackaging stared, continued to be so because of it. the Bank of England was given only interest rates as its tool to control money supply (and with certain agreements quantitative easing) and this was impotent for anything other than the short term. It needed something like the ability to impose stamp duty on the creation and secondary trading in these types of credit structures. This is a fiscal tool and is under the auspices of the Treasury and the government.

I am afraid that it is incorrect to claim specious and a display of ignorance to claim that the banks are trying bolster their balance sheet at public expense. The UK banks are now under a stricter risk regime, imposed by the regulators, that requires a greater degree of risk magnitude to be allocated to more risky ventures. SMEs have always been risky, even before the financial crisis, because of the nature and narrowly diversified scope of what their businesses face. In addition for each unit of risk, more and higher quality (and therefore higher costing) capital and liquidity (this not being required before) are required. This increases the cost of lending considerably, unless it can be mitigated and there are certain ways that have been prescribed by the regulators of how this can be done. In the particular example, you describe, the banks was being responsible to its depositors. It was also saying that past performance is no indication of the future, including future circumstances of operation. In addition, the value of commercial property had been falling even before the financial crisis.

You are wrong about your understanding of the ethos of banking regarding arbitrage. Arbitrage can only occur when there is mis-pricing, asymmetric information and disequilibrium that can be accessed. The opportunity for true arbitrage has been rare for some time. The so-called arbitrage that occurred have not been undertaking a riskless profit venture and these have not been indulged in by banks but by hedge funds and high-frequency trading companies. This is because riskless profits would mean no VaR charge. Those described are not riskless and would attract a VaR charge if they were banks and this would no longer create a profit.

I do agree with you that bankers are salesman but them they have always been. They still have to comply to the regulation and ethos of treat your customer fairly. They did less of this in PPI but then in charging PPI, they were also able to charge a lower rate on the advances than would be without the PPI. This was never brought up. However, all information should have been clearly disclosed, including this. The public still have a duty of care to themselves to read the small print and question "to the death" what they do not understand until they are comfortable and satisfied. If otherwise, do not commit to the transaction. The responsibility that is Joe Public's must be recognised and overcome by common sense, diligence and education or by seeking professional advice.

I am happy to agree to disagree on opinion but not on fact.

Verstein and Rauterberg ..

JC | | Permalink

I refer to the following in respect of your point 3

".. It is far easier to manipulate Libor than it may appear. No conspiracy is required if each bank individually expects to benefit by submitting a false quote. Under the reputational theory, any bank benefits from lowballing its quote regardless of whether it influences the final quote. As John Ewan, the BBA [British Bankers’ Association] officer in charge of Libor, put it, “it’s like a school of fish. When a shark pops up, they all jink at exactly the same moment. You think they are acting in co-ordination, but they are not…. They want to stay in the school, preferably in the middle of the school, because that is the way they are most likely not to be eaten by a shark. That’s not collusive..”

“..it is not collusive, but it is manipulative if banks tailor their quote to defend against threats, and the net result could be an artificial rate.” Further, banks may influence Libor “even if no other bank has the same idea..”

“..Any bank may manipulate the Libor rate in at least one direction unilaterally … 50% can move it in either direction, 25% can manipulate only upward, and 25% can move it only downward…. Thus it is false to say that it would have required co-ordination among more than a quarter of the banks in order to manipulate...”

Reference: http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID2103280_code1652150.pdf?abstractid=2025124&mirid=3

p.42 - Manipulation

Final words on interest rate swaps?

indiajack | | Permalink

Read what he says:

 

It takes 50% to move it in one direction!

Interpreting the rest in context of Libor setting- he means - 25% of the most excessive upward quotes will be discarded as will an excessive downward by 25%.

 

The reference only leads to the ssrn site and not the paper. If you are referencing the paper I initially linked, tread its analysis and more importantly its conclusion - No manipulation!!

 

There is a difference between being manipulative and actually manipulating/manipulation from a legal perspective and also in semantics in the way it is used.. This is the questionable behaviour but no evidence of manipulation, which is what the SSRN report I linked concludes. You also have to question what is trying to be manipulated. Libor or the view of Barclays state of liquidity in the markets?

 

LIBOR not relevant to companies entering into swaps

plega | | Permalink

Exciting though LIBOR is, fiddled or otherwise, it will have had no cost impact at all on the companies who entered into Interest Rate Swaps at the behest of their bankers. An IRS is used by a company to convert the floating rate (LIBOR) at which it is borrowing money - almost certainly from the bank in question - into an effective fixed rate. It pays LIBOR to the bank on the underlying loan, and on the Swap it either receives the difference between LIBOR and the agreed fixed rate (if LIBOR is above the fixed rate) or it pays the difference (if LIBOR is below the fixed rate). In all cases the LIBOR rate used in the IRS netting calculation will be the SAME DAY'S LIBOR FIXING as that used on the floating rate loan.

So, while fiddling LIBOR fixings may be fun, it won't alter the company's net position. As someone pointed out above, the reason companies want to get out of these IRS deals is because they took them out in case rates started to rise, and they are now annoyed because rates actually fell.

Having said that, selling IRS deals to anyone other than (professional) listed companies and banks has been a mugs game since the Hammersmith & Fulham case in the late 80s (or thereabouts).

Libor and aftermath

indiajack | | Permalink

plega - I agree with all that you say but there is a Libor link if one wants to get out of a fixed rate IRS. This is because the bank that is the counterparty will have to neutralise it exposure to receiving fixed interest as banks fund on floating rates. To offset the initial IRS with the customer, the bank would have hedge itself with an IRS with the opposite flows. If the customer wishes to terminate his fixed interest payment, the bank will have to terminate or replace the hedge it has used. This latter bit is minimally linked to Libor and hence is affected by large Libor movements. A £1,000,000,000 notional principle facing a change in Libor of 0.01% per annum will be affected by £100,000 per annum in a NORMAL loan - but the effect on an IRS will be much, much less depending on the tenor of the swap, shape of the forward yield curve and thus the discount rate to calculate the present value. The greater the tenor the lesser the effect, the greatr the discount rate the lesser the effect and the gradient at the short term end of te forward yield curve, the lesser the effect.

latter bit is minimally linked to Libor

plega | | Permalink

I should have thought that the cost of the replacement swap would depend 100% on the price of swaps (i.e. the fixed rate). Swaps always used to be priced against gilts rather than LIBOR so I would not have expected any impact of 3/6 month LIBOR on current fixed rates. On the other hand, if you're saying that there *is* a linkage between today's short rate fixing and the current 5-yr swap then yes, it will have an impact.

The fixed rate is calculated

indiajack | | Permalink

The fixed rate is calculated from the forward yield curve which is first made up of Libor because that is where the banks borrow from each other, then futures and then the last traded swap prices; and then if the swaps become illiquid, gilts are used . The "swap market"yield is thus bootstrapped together and smoothed by splining.

The zero curve is then computed to eleminate interest rates risk and then a forward curve derived from this. Then if it a fixed rate against a 6-mth floating, the 6 months strip is calculated, then the 6 month in 6 months' time and then the 6-month in 12 months' time, and so on until the fixed rate maturity is reached. The cash flows over the time periods are calculated  and then a single interest rate that discounts the net present value to zero is computed. This is the fixed rate for te swap.

The method you describe was used in the past, when the longer dated swap and FX markets were not so liquid. the government borrowing market is less liquid these days. Gilts can become illiquid if buyers take on a "buy and hold" strategy as it halts circulation and the true cost is distorted or if government is not issuing new gilts to keep a deep and liquid market. The demand-supply effect distorts the "risk-free" rate that reflects the goverment's credit rating.

The FX aspect is also considered to eliminate arbitrage.

The traded swap market is now more liquid than the gilt market and represents, if all works smoothly, the liquid market clearing price that represents the price of mney traded on  the market rather than sitting "unused" (or untraded or uncirculated in relative comparison). The true mark up for a functionaing liquid and cliearng market is what the market clearing rate is above the rate at which the government borrows.

 

The swaps being priced with Libor being included - therefore the current 5-year swap will have current Libor as an element. But the impact of a basis point is minimal because of the process I described.

 

The method you describe was used in the past

plega | | Permalink

Crikey, you make me feel old. In those days we wouldn't have had enough computing power to price a Sterling swap that way. But to go back to LIBOR, is there any way that traders from two or three banks, acting in concert with their submitters, could have affected a daily fix ?

feeling old

indiajack | | Permalink

Me too - I have to keep up with it.

 

And there is computing power now - in fact, it is a battle with computing power and efficient coding that increases processing speed. they are now about to use GPUs or Graphical Processing units and I remeber punch cards and batch processing!

Two or three  - no!  If you wish, confirm with the arithmetic.

 

In a field of 16 submitters, you would need at least 8, if the highest 25% and the lowest 25% are discarded. An easy way of reducing influence even more is to increase the 16 to another even number.

 

Still confused ....

JC | | Permalink

According to the following extract, the authors(s) claim that it would only require one bank to manipulate the rate

'.. Imagine a panel of eight banks A, B, C, D, E, F, G, and H, with “true” costs of 1,2,3,4,5,6,7, and 8, respectively, which is their Libor quote on Day 1. Banks C, D, E, and F are included as the middle band and A, B, G, and H are excluded as outliers, so Day 1ʼs Libor output is ((3+4+5+6)/4) or 4.5 On Day 2, none of their costs change. Which banks can manipulate the daily Libor? Surely C,D,E, and F can each individually manipulate the outcome either by increasing or decreasing their quote (3+4+5+6 +/- n)/4= 4.5 +/- n/4.

Of course, there is a limit to how much manipulation can be achieved in this way. If C lowers its quote to 1 from 3, it will cease to be part of the middle band. Its quote will be excluded by virtue of being in the bottom quartile. However, Bʼs quote will no longer be part of the outlier direction, at least 75% of the panel banks may unilaterally affect the average by moving the quote in their preferred direction. Thus it is false to say, as many do, that would have required coordination amongst more than a quarter of the banks in order to manipulate Libor. Such coordination would be necessary to ensure manipulation power in both directions, but any individual bank can effect manipulation in at least one direction

The included panel will be B,D,E, and F with quotes 2,4,5, and 6 respectively, and the dayʼs Libor quote will be 17/4 or 4.25. To be sure, Cʼs manipulation was blunted by the exclusion rule , since she lowered her quote to 1, but the value submitted to the average dropped only to 2. But she was still able to unilaterally move the range and lower the average by 0.25. The same thing would happen if C, D, E, or F were to submit a quote higher than the middle band; they would be excluded from the calculation, but pull a previously excluded outlier into the band.

The outliers themselves cannot manipulate the Libor by submitting a false quote within the same excluded quartile, but a false quote that moves to the middle band or the other quartile will change the output value. That is, B cannot manipulate the output by submitting a quote of 1 instead of 2. B's quotes are already too low to be included. But if B submits a quote of 4, then she joins the middle band, which now stands as B,D,E, and F with quotes of 4,4,5, and 6 respectively, or 4.75. Similarly, B can alter the range if B submits a quote that is too high to be included. If B changes from 2 to 9, she pushes G into the middle range. Thus the middle range becomes D,E,F, and G with quotes of 4,5,6, and 7 respectively. The average value jumps to 5.5 Again, Bʼs manipulation was dampened by the exclusion system; Bʼs submitted a quote that was 7 higher than her real value, but the Libor average only went up by 1. Still, she was able to change the value without any assistance.

If the middle range involves more than 50% of the panel banks, then even more banks may manipulate in either direction. In fact, fewer than 50% of the bank quotes are excluded because banks with quotes that tie the middle 50% are included. Thus, from January 2, 2007 until August 8, 2007, 95% of panel quotes were included in the average. Abrantes-Metz et al., Libor Manipulation?, 36 J. Banking & Fin. 136 (2012). During that period, more than 95% of the time, a bank could influence the Libor total by changing its quote ..'

Granted that these may well be artifically engineered figures, but they would seem to be at odds with claims that a single bank cannot effect the rate, and in fact the Excel example below seems to indicate this is possible - i.e. a single bank changing the rate from 4.5 to 4.25

Perhaps someone could explain why this is not a vaild argument

Misleading analogy

mikewhit | | Permalink

These swaps should not have been portrayed as an "insurance policy".

With an insurance policy, you pay a premium and that's the limit of your financial exposure. If the event insured against occurs, you get some recompense.

valid argument

plega | | Permalink

Yes, it is an interesting argument, and valid. But it depends on several non-obvious factors, like what is the spread between banks; how many of them are actually submitting the same rate; is the bad banker in the inclusion or exclusion zone; does he want to push the rate up or down.

But the thing is, 30 years ago, when LIBOR first started being used for derivatives transactions, nobody on the cash desk would have listened for a moment to a spotty youth from the swaps team, if he even knew who he was. They worked for different departments of the bank, and the treasury reported on the banking side. So none of us even considered LIBOR manipulation for a moment, and we certainly didn't bother to analyse the circumstances under which submissions could affect the market. We were too busy trying to make money.

misleading analogy

plega | | Permalink

Not at all. Think of it as "immunisation". Yes, the payments could go both ways, but for a UK corporate who swapped floating rate bank debt into fixed, he had the certainty that he craved. Not at all necessarily a bad deal.

inappropriate example.

indiajack | | Permalink

JC,

 

The example is structured incorrectly and not for for purpose - I would question that authors' ability to analyse the impact of 1 basis point in the submission:

 

Arithmetically, in the field of the 16 Libor , the highest 4 and lowest 4 will fall out. The value of 1 basis point increase from any undiscarded submitter is £34 a day on a principle of £1bn. If all 8 colluded, the 1 basis point would be worth £272 a day. This would assume that each of them have a net exposure outcome (after different directional position have offset each other) of £1 billion in the direction of the 1 basis point increased by collusion.

All submitters must be positioned to gain in one direction, an increase or decrease. It also assumes that no submitter can renege and profit by undercutting (or the opposite depending on whether it is an increase or decrease).

 

Anyway, this subject has been rigorously answered. There has been no Libor manipulation and that is it!

Please provide your own example ....

JC | | Permalink

You seem to be making a presumption of a 1 bp change, although evidence indicates nearer to 30-40 bp pa for the ears in question

So working on 1bp=0.01% and being conservative with 1 bank (H) submitting a fix of 10bp=0.10% we seem to have the following:

@indiajack - since you clearly disagree with the above figures please be so kind as to post your own example (in simple terms) so that I can understand your stance

Perfectly willing to be convinced and an example would make your case incontrovertible

Lies, Damned Lies and LIBOR

plega | | Permalink

I have taken the submission figures for the first 5 months of 2005 for USD 6m LIBOR. I could have taken more but I wanted a period which would demonstrate the opportunities for cheating (if any) at a time without abnormal market stress. Here are the figures:

5 months
101 fixings
16 banks (i.e. 16 submissions per fixing)

For each submission I have calculated the absolute variance from that day's fixing. Variances were:

Number of submissions between 5-10 b.p. 1
Number of submissions between 3-5 b.p. 2
Number of submissions between 2-3 b.p. 14
Number of submissions between 1-2 b.p. 173
Number of submissions between 0-1 b.p. 527

Obviously this is a very brief and superficial analysis. For the period in question, indiajack is justified in saying that one basis point is a reasonable variance for a bank trying to push the rate, and the actual benefit from doing so is vanishingly small if indeed it has any impact. Of course, you can look at the actual submissions to see if, on any particular day, any outliers actually did have any impact. I would be surprised if, for the data I have analysed here, there is any evidence at all of outliers having an impact on the fix.

In any event, based on these figures, we're back to sub-one basis point impacts and a resultant cost to the poor swap victim which won't have been enough to be worth retaining a lawyer.

own example

indiajack | | Permalink

JC

I already have provided examples.

You need to be more arithmetically astute.

I have work to do rather than working out an even simpler example.

 

Sorry but no more

@indiajack - agree

JC | | Permalink

That on the basis of 1 bp a single bank would not be able to influence the overall situation

Nevertheless, bearing in mind that

LIBOR is an average rate at which panel banks believe they can borrow in the interbank market over various time periods, rather than an actual or tradeable rate

Could the banks ever be found guilty of manipulation because their 'get out of jail card' is the rate at which they 'believe' they could borrow and not necessarily the actual rate

Surely all they would need in defence is to say that their 'belief' was incorrect and purely a best estimate?

Now if there was a comparison between Banks actual rates and submitted libor rates then that may reveal a different situation

Although as I read it, there may be be two camps - high & low submitters

High - Barclays, BTMU, Credit Suisse, HBOS, Norinchuckin, and RBS

Low - Citi, HSBC, JP Morgan, Lloyds, and Rabobank

With Barclays & JP Morgan leaders at opposite ends of the scale

Reference - LIBOR 2005-2008 

https://docs.google.com/spreadsheet/ccc?key=0AonYZs4MzlZbdEtRNnA4SWx1djhTSHpyYVliQ1pFb2c#gid=0

 

Belief isn't an issue here

plega | | Permalink

Without looking carefully at the figures, I think you're going to find that the dates on which there was the widest divergence were the dates when there was no interbank trading going on at all, because *all* the banks were worried about each other's liquidity. I don't have any stats about when that situation pertained but it was certainly discussed in the press at the time. With no interbank trading to compare against, all discussion of the "right" rate for LIBOR becomes, technically, "academic".

That's not to be confused, of course, with attempted manipulation by individual traders (or possibly groups of traders) which we are to understand happened in 2005. There is *no* defence against that, of course. But, equally, as we have discussed above, it's not at all clear that any of the attempted manipulation in 2005 necessarily had any impact on actual fixings.

information loss

indiajack | | Permalink

JC,

 

You do not have the information to make any reasonable inference on the two camps.

It could be that HBOS was doing more risk businesses and therefore had to increase its Libo bid or it had borrowed more money previously to fund or needed to borrow more, so it would bid higher.

 

Lloyds could have not done anything but the mundane and therefore did not need to borrow so it would bid low.

 

There are so many similar posibilities that would exclude a Libor fix.