By Mike Antich
LIBOR is a benchmark interest rate that is widely used as an index in trillions of dollars of lending and borrowing transactions around the globe. LIBOR, an acronym for London Interbank Offered Rate, is used as an index to establish the cost of borrowing and lending to consumers, businesses, municipalities, and the capital markets.
LeasePlan was the first fleet management company to use LIBOR as a funding index for fleet leases. It started doing so in the early 1990s. Up to then, the fleet leasing industry used commercial paper as a funding index. Several years ago, other major fleet management companies also started using LIBOR-based funding as a primary index. One reason was that fleet management companies were increasingly receiving fleet RFPs asking for vehicle funding to be indexed to LIBOR.
"The lessee's own corporate debt was oftentimes based on a LIBOR, so it made it easy for them to compare their lease funding to their own funding," said Greg DePace, senior vice president of finance for Emkay.
Beside this, there were other reasons why some lessees and lessors gravitated toward LIBOR as a funding index.
"Historically, LIBOR has been a publicly available number that reasonably correlated with fleet leasing companies' cost of borrowing," said Dan Frank, vice president and general manager for Four Wheels at Wheels Inc. "Our customers found it useful in assessing different competitors in the marketplace, because it was a fairly consistent number that could be used as a benchmark."
Questions about LIBOR Accuracy
LIBOR was developed in 1984 to satisfy demands for an accurate measure of the real rate at which banks lend money to each other. LIBOR rates are published daily by the British Bankers Association for 10 major currencies and 15 maturities, ranging from overnight to one year. LIBOR is a floating rate, calculated each day based on the interest rates for unsecured funds banks lend to each other in 10 currencies in the London interbank market. The index is based on self-reported numbers submitted by 16-member banks as to their cost to borrow 30-day money. The index is not based on actual trades, but on what each of the banks self-reports to the British Bankers Association.
However, a controversial article was published in the May 28, 2008 edition of the Wall Street Journal (WSJ) questioning the accuracy of the LIBOR index. The article raised questions about several banks of the 16-bank panel that reports daily the rates used to calculate LIBOR in dollars. Suspicions were voiced by other bankers that allegedly these rivals may have been low-balling their borrowing rates. These suspicions started in late January 2008 as fears grew about possible bank failures and these concerns gained intensity with the collapse of Bear Stearns in mid-March. Suspicions grew that some banks were allegedly understating their borrowing rates. The speculation was that if a bank submitted a much higher rate than its peers, it risked giving the appearance it was in financial trouble. As a result, the WSJ article said banks had an incentive to play it safe by allegedly reporting somewhat similar rates, which would cause the reported rates to cluster.
After Lehman Brothers filed for Chapter 11 bankruptcy protection Sept. 15, 2008, the interbank lending market froze up, affecting both LIBOR and the markets. "While historically lessors could match-fund their book of business, now it was a significant risk that short-term liquidity may not readily be available," said Dave Dahm, chief operating officer for LeasePlan USA. "This may cause some to move away from the very popular LIBOR-indexed pricing into new benchmarks."
Also during fourth quarter 2008, concerns grew about the viability of many banks. As banks around the world began to get "stressed," critics speculated some banks began to allegedly under-report their cost of borrowing, not wanting to reveal that other banks would not lend to them or would lend to them only at higher rates. "There was talk about changing the way banks report by using a trade rate versus a self-reported rate. LIBOR was starting to become a non-meaningful number," said Frank.
The end result was a tremendous amount of confusion in the fleet leasing market concerning not only LIBOR, but all indices used in floating rate leases. "A recent discussion with a purchasing manager of a company reviewing bids from six fleet management companies said he had been quoted lease rates based on six different indices," said George Kilroy, president/CEO of PHH Arval. "My experience has been that it is difficult for lessees to make accurate comparisons, even when including a treasury representative."
Despite this market turmoil, LIBOR continues to be used as an index for certain fleet funding arrangements. "Most syndicated funding deals from bank groups today still utilize LIBOR as a basis for the deal, and we do not see that changing," said DePace of Emkay. "However, the spreads (or markups) being charged are significantly higher, as banks look to earn larger yields, even from investment grade companies."
Impact of Government-Backed Borrowing
As the global financial crisis worsened, the governments of many major economies grew concerned with the possible failure of their national banking systems. One by one, governments started guaranteeing the debts of their banks. These guarantees took several forms. In one case, the Royal Bank of Scotland, a member of the 16-bank LIBOR panel, was essentially nationalized by the British government. In other countries, the government guaranteed the interbank lending of banks. In the U.S., programs such as TARP were created and large sums of capital were injected into banks to increase their liquidity. More importantly, the U.S. government has publicly stated that it will not allow the 19 largest U.S. banks to fail. These governmental interventions began to distort financial benchmark rates, such as LIBOR.
"Government intervention has impacted several floating rate indices - not only LIBOR, but commercial paper rates quoted by the Federal Reserve - distorting the relationship between the lessor's price and their cost of borrowing to support lease transactions," said Kilroy of PHH Arval. "Fortunately, funding costs, in some cases today, like TALF, are being tied to LIBOR, which will make a closer match possible."
When governments began "backstopping" bank borrowing, the cost of lending money began to represent a government-guaranteed rate. "Currently, LIBOR is no longer reflecting the cost for a highly-rated financial institution to borrow. Instead, it reflects the cost to borrow from governments," said Frank. "When LIBOR went from being a bank-borrowing rate to a government-borrowing rate, it no longer correlated to fleet lessor costs."
The divergence between the cost of governments to borrow versus the cost of corporations to borrow widened appreciably during the recent financial crisis.
Over the past 10 years, the difference between a two-year Treasury note and a two-year AA bond might have been 75 basis points. When the financial crisis deepened, the difference between two-year Treasuries and two-year corporate bonds went to 500 basis points. The premiums corporations pay over the government rates have expanded significantly. Government-guaranteed bank borrowing created the same dynamics in LIBOR, which no longer represents a corporation's cost of borrowing.
From 2002-2005, pricing ranged from LIBOR +8 to 36 basis points for two-year to five-year AAA securities and LIBOR +38 to 70 basis points for A and BBB securities. This changed dramatically when compared to January 2008 and January 2009.
"There are various financing alternatives which can reflect investment grade borrowing rates, and most CFOs and treasurers of companies understand these alternatives. They also understand the LIBOR spread adjustments recently seen in the credit market, as most have seen some sort of upward adjustments in their own credit facilities," said DePace of Emkay. "Today, higher leveraged companies are seeing even larger adjustments as banks today have much less appetite for risk and expect larger returns as a result. More conservatively run companies have an advantage today, as they probably don't need to access money as frequently, and get lower overall rates."
One unknown is the future relevance of LIBOR as a fleet index. Fleet lessors, who in the past have marketed leases simply as a markup over LIBOR, face a new market reality.
Let me know what you think.