LIBOR Rates on interbank lending
Kevin Bourque worked for a global asset finance bank for 6 years as head of legal for the largest division in that bank. He is now a Senior Counsel at Hughes Krupica based in Bangkok. During the financial crisis, it became apparent that larger AAA rated banks that formed the British Bankers Association (BBA)'s panel banks were NOT offering London Inter-Bank Offered Rates (LIBOR) on their interbank lending (as reported on Telerate and Reuters screen rates) at those rates. Consequently, loans at LIBOR by financial institutions had to honor the fictitious rates and they incurred huge losses when they were forced to pass on the fictitious rates to their clients and not charge their actual cost of funds which represented their real cost of funding loans.
Real Rate = Agreed Notional Floating Cost
The real cost was always agreed with the customer to be the agreed notional floating cost (LIBOR + in the case of non AAA rated banks) which was lending cost and did not represent any profit margin. The LIBOR funding was simply a "pass-along" cost of lending only. Hence, smaller banks (non AAA rated) went quickly underwater in losses with their Borrowers as LIBOR losses cut into their margins erasing profits and barely, if at all, meeting their actual funding costs.
Two Prong Solution
There seemed to be a two prong solution to this background and foreground lending problem. The first was to invoke an esoteric clause in loan agreements called "market disruption" which deals with an analogous scenario never contemplated by the market that allowed financial institutions to recoup their losses on Libor in earnest. This meant invoking the clause and charging the customer it's actual costs. Not all loans had the right language but by invoking it the banks could use the threat of no new lending or accelerating loans to push through its "actual funding costs". This in itself led to huge windfalls for some banks during the financial crisis because they charged their real cost of funds.
The second prong that led to larger bank profits was tailoring LIBOR so that banks could charge actual cost of funds going forward. There were so many versions of the London Loan Market Association standard leverage loan's Market Disruption definition that it was imperative to have the latest one that seemed to cover this sort of event but even better to tailor your own "clause". It became imperative to introduce a LIBOR/cost of funds provision that was based on actual broker quotes and swap rates which were the "actual" rates at which banks WOULD lend to each other since these rates were "actual" transactions happening in the market and reflected real basic costs of lending . This was then plugged in and the bank would make its actual profit margin. Windfalls were in order for 2008-2010 with this new definition for banks that used it, others that didn't lost huge amounts of money on the discrepancy for fear of alerting shareholders they couldn't get Libor at the Reuters reported rates.
Deferral of Loss Structure
The last chapter in the banking story which was written was the "deferral of loss" structure that saw keeping an asset's loss away from the balance sheet by preserving and enhancing the security package even after the asset was foreclosed while the other security collateral was held up in bankruptcy proceedings. When assets were repossessed there was and still is an original mechanism to make use of the new financed asset held in Special Purpose Company's or Vehicles (SPC's and SPV's). These SPV/C's were indirectly controlled by the financial institution in offshore Trust structures. The goal was to provide security to the old lending structure to keep hope of a recovery of losses alive, possible fictitiously in some cases, during the length of the bankruptcy period involving the other collateral. This meant suspended animation of loan losses for that period which the bank had hope that trading the repossessed asset at improving market rates or waiting for an economic turnaround on the asset value could offset the losses or diminish them when the old security package was worn out (when the bankruptcy period ended and it was apparent there was no collateral to offset the loss in the old package).
Finance Technique for Today
In this new virtual cross collateralized structure the new lending may or may not have produced enough income to offset the loss during the time the bank had won during the bankruptcy court process. However, it was a mechanism to make earnest legal time for a better outcome for the financial institution. This strategy is still a very relevant technique today especially now that certain shipping segments have gone underwater again and loan provisions and losses are beginning to add up heavily as before. It's déjà vu all over again!
At Hughes Krupica, Kevin continues to provide financial institutions with advice on pushing out losses legally while gaining some time to offset them.
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