libor

 

 

 

 

I have to admit I don’t have much sympathy for those who lent or borrowed at floating rates like LIBOR.  Personally, I have always preferred fixed-rate deals where everything is locked in from the beginning.  It means the terms are fixed, and either you can meet them or you can’t.

There are two problems with floating rate deals.  The first is that you can’t control your funding costs.  This stems from two things: short rates are volatile, and the index is typically not controlled, though it often acts like it is.  Here is an example: there were mortgages that floated off of the one-year Treasury Note rate.  Then the Treasury cancelled the one-year Treasury Note auction, and investment banks scrambled to come up with a substitute.  As I recall, they used the interpolated rate on six month bills, and two year notes.

When I was a corporate bond manager, aside from rare occasions, I never bought floating rate debt.  Why?  I needed more certainty for the client.  Fixed rate bonds and loans are more certain.  When you float, you are subject to the vicissitudes of the index, whether a borrower or a lender.

Whatever else is true, you do not control a floating rate index.  If a related party has some influence on it, that is a negative surprise, but there may be nothing illegal about their influence, particularly if it is moderate as is likely with LIBOR.

As I say to so many others in related situations: don’t give others options against you; don’t play in their casino by their rules.  Average people should not let financial institutions have variability of terms; terms should be fixed to the greatest extent possible.

And, why do borrowers go for floating rates, if they can be harmed by them?  Because they are cheaper on average.  Yield lust works on the downside as well, and many borrow shorter than is prudent for them, in order to save a little.  Works most of the time, but not all of the time, and when it doesn’t work, it can be ugly.

Thus I encourage fixed rate finance, as always, and encourage lenders and borrowers to fix their financing in advance.

I have to admit I don’t have much sympathy for those who lent or borrowed at floating rates like LIBOR.  Personally, I have always preferred fixed-rate deals where everything is locked in from the beginning.  It means the terms are fixed, and either you can meet them or you can’t.

There are two problems with floating rate deals.  The first is that you can’t control your funding costs.  This stems from two things: short rates are volatile, and the index is typically not controlled, though it often acts like it is.  Here is an example: there were mortgages that floated off of the one-year Treasury Note rate.  Then the Treasury cancelled the one-year Treasury Note auction, and investment banks scrambled to come up with a substitute.  As I recall, they used the interpolated rate on six month bills, and two year notes.

When I was a corporate bond manager, aside from rare occasions, I never bought floating rate debt.  Why?  I needed more certainty for the client.  Fixed rate bonds and loans are more certain.  When you float, you are subject to the vicissitudes of the index, whether a borrower or a lender.

Whatever else is true, you do not control a floating rate index.  If a related party has some influence on it, that is a negative surprise, but there may be nothing illegal about their influence, particularly if it is moderate as is likely with LIBOR.

As I say to so many others in related situations: don’t give others options against you; don’t play in their casino by their rules.  Average people should not let financial institutions have variability of terms; terms should be fixed to the greatest extent possible.

And, why do borrowers go for floating rates, if they can be harmed by them?  Because they are cheaper on average.  Yield lust works on the downside as well, and many borrow shorter than is prudent for them, in order to save a little.  Works most of the time, but not all of the time, and when it doesn’t work, it can be ugly.

Thus I encourage fixed rate finance, as always, and encourage lenders and borrowers to fix their financing in advance.

 

By David Merkel, CFA of Aleph Blog