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Some called it the “world’s most important number” and by the end of 2021 it will no longer be published, according to the U.K. Financial Conduct Authority. The absence of the now infamous LIBOR benchmark may force market participants to rethink credit calculations, standardized benchmarks, lease contracts, and financial reference calculations such as the “risk-free rate”. What will replace one of the most prominent references in global financial markets?
It’s well known at this point that confidence in LIBOR, or the London Inter Bank Offer Rate, was shaken after it was revealed that the rate had been manipulated by a group of colluding traders at some of the world’s largest banks. The manipulation of the reference rate was baked into the underwriting of an almost unimaginable $350 trillion in estimated value* of global financial transactions. For what may well be the largest scale financial crime in history, and with many tangible victims (for example, a Cleveland Fed study found that around 60% of all U.S. mortgages were based on LIBOR) the rate itself is not necessarily comprised of any reliably measured statistic, hence the ability to manipulate it. LIBOR is the rate banks expect to charge each other for short term borrowing (rates from overnight to a year in duration) but over time these institutions stopped borrowing from each other, and the rate became detached from its fundamental purpose of publishing expected borrowing costs for member banks. As news of the scandal broke, regulators stepped in and began the process of shutting down LIBOR and holding bad actors responsible.
What is less talked about today is how LIBOR manipulation continues to impact previously underwritten vintage real estate debt, the valuation and discounting problems associated with removing global benchmark, and exactly what the replacement of LIBOR will look like. LIBOR is a reference rate baked into everything from private equity IRR metrics to residential mortgage loans. Its widespread use as an alternative measure of a risk free rate normally found in yields on Sovereign bonds or the Consumer Price Index (CPI) numbers, means that global real estate investors have had exposure to LIBOR at all parts of the industry food chain. Developers, Asset Managers and Investment professionals all have exposure to LIBOR in some form and its replacement will soon have to be implemented as portfolios turn over and the index ceases to be calculated. The question for us is, what’s next?
It’s clear that the next rate proxy must be grounded in a liquid, transparent and likely asset backed market so history doesn’t repeat itself. What’s less clear is if regional or sector specific indices will surface to fill the void left by LIBOR. For instance, using the rate on an asset backed overnight loan with short term U.S. treasuries as collateral might be attractive to U.S. investors but will that risk-free proxy hold water in areas of the world where LIBOR was more prevalent or in industries where it was referenced more often? Since LIBOR was denominated in many currencies and was a familiar standard globally, it could be challenging for investors conducting transactions across countries or continents to come to an agreed upon standard as they jockey for position or better deal terms.
With the developed world still pursing accommodative policies and perpetuating a low rate environment, these differences may be understated now, but as normalizing occurs, differences in calculation would become more pronounced. How might derivatives be priced and how will the hedging market evolve with new benchmarks? It’s easy to imagine the financial difficulty that globally minded investors might have if valuations and derivative pricing models differ significantly in their benchmark rate calculations. Liquidity seems to be very healthy in the current environment and capital flows move with relatively little friction, but perhaps fragmentation in risk-free calculations could impact liquidity and ultimately make capital allocation more inefficient. Investors would have to, for example, consider adding detailed discounting/premium calculations when modeling inflation/market adjusted leases, mark-to-market derivatives or what appropriate haircut to give collateral on a loan.
As real estate professionals competing in a global market, even the benchmarks we use to measure our own returns may have to be backtested and replaced by something new. The fallout from the scandal could be nearing an end for those that perpetuated it, but it’s possible it may just be beginning for market participants seeking clarity around the LIBOR replacement.
What are your thoughts on a LIBOR replacement? We want to hear from you so feel free to reach out in the comments section for this post on LinkedIn.
*Huw Jones, October 3, 2017, Bank of England says reliance on Libor poses risk to stability, Reuters, Retrieved from Reuters website https://www.reuters.com/article/us-boe-libor-markets/bank-of-england-says-reliance-on-libor-poses-risk-to-stability-idUSKCN1C815T