The LIBOR Scandal – LIBOR’s Effect on Construction

What is LIBOR

Frequently, construction loans and commercial note interest rates are “pegged” to LIBOR rates (i.e. LIBOR +3%).  Established in the 1980s, the London Interbank Offered Rate (“LIBOR”) is an interest rate commonly used throughout the world (and here in the U.S.) as a loan benchmark. The LIBOR is the average participating banks must pay to borrow from one another. This average is determined through self-reporting from the banks with the highest and lowest reported rates discarded, the rest averaged, and the LIBOR is then set. LIBOR affects approximately $800 trillion in securities and loans. By way of comparison, the U.S. GDP is $15 trillion.

Long-term loans suffer, at least from the bank’s perspective, from the chance that markets will change and the agreed-upon rate will not turn a profit. Floating rates, such as LIBOR, allow borrowers access to credit, and give banks peace of mind knowing that a rate will periodically reset based upon the cost of funds to a bank. For example, if a loan were priced three percentage points above LIBOR, a bank would face little danger from volatile markets.  The interest rate charged its customer is reset to LIBOR, and the bank is assured of getting a reasonable return on its investment.

The Current Scandal

Government investigations of participating banks has revealed manipulation of the LIBOR by participating banks. The bank-reported loan rate data is not monitored for accuracy by an independent agency. Instead, the system relies on banks truthfully reporting loan rates. But why would a bank lie about its borrowing rate? First, banks which report high rates implicitly convey that their credit is less than stellar. Like consumers, strong, low-risk banks are afforded low rates. Therefore, a bank with a high borrowing rate may be inclined to fudge its numbers so as to appear more financially solid than it truly is.  Additionally, banks invest in other investment vehicles aside from simple loans. Those investments also may hinge upon the LIBOR rate; therefore, a bank could use its manipulated rates and insider information to take advantage of the market.

The Scandal’s Effect on Construction

Not all the facts are yet in. We don’t know how far back LIBOR manipulation was taking place, nor do we know how many banks participated in this duplicitous behavior. What we do know is there was rate manipulation which resulted in the LIBOR being reported lower than it should have been. If you have a loan set to LIBOR, this is somewhat good news for that loan. However, likely, because the rates were not swung enough to greatly affect a consumer loan, individuals are not thought to have been much affected.

During the financial crisis banks were lending in the open market at lower rates and collecting less return on those loans. The banks’ clients’ investment vehicles such as pension funds, mutual funds, and adjustable rate mortgages, in turn collected less money on their investments. Those investment vehicles directly pay out to cities, governments, and financial institutions which fund hospitals, police departments, fire departments, schools, libraries and other public services. Therefore, money which should have gone to these public entities, instead enriched bankers. It also then follows that the city and government entities which fund construction projects had less money to engage in construction work.  The bottom line is the LIBOR scandal likely had little direct effect on consumer and commercial borrowers, but did reduce the capital available to public works projects, and the banks benefited from this scam at the expense of all taxpayers.

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