By Chris Harrison and Judy Howell
KyForward contributors
It’s funny how we often don’t recognize or completely understand things that can have a major impact on our lives. I don’t pretend to understand how my computer works, and when the tech guy starts talking, my eyes glaze over and I pretty much stop listening. What I really love is when I have a blue screen that tells me I have a “fatal error.” I still haven’t figured that out, but just because I don’t understand it doesn’t mean that it won’t impact me.
We may feel the same way when we hear about scandals within the financial system. Even though we read and listen to the reports, it still may be difficult to completely understand what has happened. And, therefore, we have the tendency to dismiss them (think of that blue computer screen).
Unfortunately, most of these financial scandals have the ability to impact you far more than you may realize. The LIBOR scandal is a great example.
First, most people don’t readily recognize the term LIBOR (are you sure it isn’t LABOR?). When you find out that it stands for London Interbank Offered Rate, you may be truly convinced it doesn’t impact you. Ah, but it does!
The LIBOR is tied to, and serves as the basis for, $350 trillion in derivatives (anything that derives its value from another asset) and other financial assets). It serves as the basis for mortgages, student loans, credit cards and corporate loans. Once we start talking about interest rate swaps, forward rate agreements, swaptions, range accrual notes, etc., the eyes start glazing over. (On a side note: In 2012, 45 percent of adjustable rate prime mortgages and 80-plus percent of subprime mortgages used LIBOR as their basis.)
The LIBOR is the main benchmark for short-term rates and is calculated every day at 11:30 a.m. by Thomson Reuters. It reflects what the leading banks in London think they would be charged if they borrowed money from other banks. The banks are supposed to report the rates they are actually paying or would expect to pay. The LIBOR is calculated for 10 currencies and 15 maturities, and the maturities range from overnight to one year. The LIBOR that is calculated for the U.S. Dollar has 18 banks that submit rates. Of those 18 submissions, the top and bottom four are thrown out, and the remaining rates are averaged. This is a very simplified explanation!
So, what is the scandal about? Investigations have been launched as a result of allegations that some banks manipulated the rates to reflect lower borrowing costs. The allegations started with Barclays Bank, and their CEO admitted to fixing the rates at his firm and, consequently, resigned. Barclays was fined $453 million. Twenty additional banks are part of the ongoing investigation. In fairness to the Barclays, it is necessary to note that the Bank of England had several conversations with Barclays about why the UK LIBOR was not falling as quickly as the US LIBOR. Were they encouraged to lower their rates? Who really knows!
What is the big deal? Isn’t it good for us, if our mortgage rate is tied to LIBOR, that rates be lower? Well, it seems that the banks weren’t really interested in keeping our mortgage rates low when they did this. The banks typically had two reasons for manipulating the rates:
1. The bank traders’ transactions would benefit by lower rates.
2. Their bank seemed more stable, particularly during the 2008 financial crisis.
Remember, too, that some savings accounts are tied to LIBOR. There are bonds that have interest rates that are tied to LIBOR. So, if you are a saver (yeah!), you probably have been penalized by artificially low rates.
The biggest problem (other than it’s illegal!) is that anything that erodes confidence in the financial systems and markets causes people to pull back and slow down. When the economy is booming, a scandal like this won’t cause as much of a drag as it does when the economy is NOT booming. It is sometimes a daunting challenge deciding on a course of action, but it is doubly hard when you feel like you are not getting accurate information or that the cards are stacked against you.
The moral of the story is that it pays to try to at least keep track of the goings on in the financial industry and even more so if you can craft a passing understanding of the impact it has on you. Easier said than done sometimes, but important nonetheless.
Christina Harrison and Judy Howell, H2 Investments, are affiliated with First Kentucky Securities Corporation (member FINRA, SIPC). They have over 25 years of experience assisting individuals in meeting their investment and retirement goals.
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