On December 20, 2012, the third presenter at the GARP webinar on the LIBOR scandal was Robert Maxim, director of Complex Asset Solutions at Duff & Phelps. He spoke about the valuation implications of incorrect LIBOR rates.
The cash flow of many financial instruments is indexed to LIBOR, he said, for big companies as well as small, and even for individual consumers such as those holding private student loans. Maxim considered an interest rate swap example in which the floating leg is tied to LIBOR. The valuation is always computed on the difference between the fixed and floating leg. “The rates used were thought to reflect generically the rate at which a bank could borrow,” he said. Or were they?
It is difficult to unwind the false rate properly because “if traders knew the BBA LIBOR would be lower, they may have adjusted the swap terms to compensate,” Maxim said. “Due to uncertainty of LIBOR manipulation, the valuation effect may be muted.”
In response to a question from the audience, Maxim replied that banks were profiting from swaps by choosing their positions so that their revenues would increase if LIBOR decreased.
Another question was whether technology was indeed available to look at lots of granular transaction data in real time. Maxim said yes, real-time rate determination is now standard practice at a number of large banks.
Maxim sketched out the effect on structured products. For collateral, imperfect hedges may gain or lose. The interest rate received from collateral would be spuriously low. For notes, LIBOR being too low would mean smaller interest payments to noteholders than what should have been. This would increase the stress on the collateral, and it may have led to an undeserved decrease in the credit quality of notes. “The effect is quite mixed,” said Maxim. “The net effect requires a detailed examination of collateral, hedges, and structure.”
That translates to a lot of detailed work over the months to come.ª
The webinar presentation slides can be found at: http://event.on24.com/r.htm?e=547384&s=1&k=36B76CF8E61746B331EA26D40448235C