The LIBOR Mess

Last week, Barclays Bank admitted that it secretly manipulated LIBOR rates for years, all to pad its own bottom line. And Barclays is not some lone, bad apple.

Investigators in the United States, as well as in London, Brussels and Tokyo, are hard at work looking into reports of similar manipulation by other big players, including Citigroup, Deutsche Bank and JPMorgan Chase. This could well turn into the largest consumer fraud ever seen.

It will take months for the general public to catch up or catch on to what this latest scandal is about. It starts with one basic fact: LIBOR interest rates are not set by the supply and demand for credit, like many other rates.

Instead, every morning, representatives of the 18 largest Western banks report on what they would be willing to pay to borrow funds from each other (“interbank”) in the future.

LIBOR rates are a very big deal, because they are benchmarks for countless other interest rates. The majority of U.S. adjustable-rate mortgages, for example, are set at a LIBOR rate plus two or three percentage points. So are millions of student loans, auto loans and credit card finance charges.

LIBOR rates also are used to set or reset small business loans, futures contracts and interest rate swaps. All told, an astonishing $360 trillion in loans around the world are indexed to LIBOR. That is more than five times the value of the world’s entire GDP this year.

One reason that LIBOR has such a far reach is that there are numerous LIBOR rates for different purposes. Each rate has a time frame — rates for loans one day from now, one month, three months and six months out, as well as one year, five years and ten years from now, and so on. There are 15 such time frames, all told.

In addition, separate LIBOR rates also are provided for dollars, euros, yen and seven other currencies, making them truly world-spanning. The integrity of these interest rates, however, depends entirely on the honesty of banks reporting the rates they would actually expect to pay. Inevitably, we got what we should have expected.

So, when Barclays (and almost certainly others) had investments that paid off, or simply paid off more, when interest rates rose, it simply reported a higher figure to LIBOR in order to nudge up the average. And that usually led to higher interest rates for millions of other businesses and people with loans indexed to the LIBOR.

Sometimes, it worked the other way. In late 2008, Barclays (and probably others) lowballed the rates they reported for LIBOR averaging.

The purpose was to make themselves look sounder than they actually were, since they would be willing to borrow only at low rates. They presumably figured that might reassure their shareholders and perhaps even dampen public demands for tighter regulation.

Something funny was going on

For several years, academics and a number of market followers warned that something funny was going on with LIBOR. The evidence was not hard to find.

For example, the “spread” or difference between U.S. Treasury rates and LIBOR rates for loans of the same time frame began to widen. From 2000 to 2006, LIBOR rates averaged one-quarter of one percentage point above Treasury rates, and the two rates moved up and down together in lockstep.

In 2007, however, that spread more than doubled to nearly two-thirds of a percentage point, and their movements up and down did not track each other so closely. By 2008, the difference in the rates was five times what it was in 2000-06, averaging 1.3 percentage points, and the up-and-down movements of the two rates no longer tracked each other.

All of the obvious authorities that might have done something about it — the Federal Reserve or the Securities and Exchange Commission in the United States, or the Financial Services Authority in Britain — apparently looked the other way. This tolerance for interest rate manipulation has cost millions of ordinary Americans and Europeans a great deal of money.

Early analysis suggests that for several years, the LIBOR was off by an average of 30 to 40 basis points. (A hundred basis points equal one percentage point in an interest rate.) That is enough, for example, to add $300 to $400 to the monthly cost of a $100,000 loan.

In 2007 and 2008, Americans held $11.1 trillion in outstanding residential mortgage debt. At the time, between 30% and 40% of that debt carried adjustable rates. If the bankers’ manipulations of the LIBOR was responsible for raising LIBOR rates by just 20 basis points in that period, their shenanigans added between $6.6 billion and $8.9 billion to the yearly interest paid by U.S. homeowners alone.

And those mortgages account for less than one percent of all of the financial assets and instruments affected by manipulated LIBOR rates.

LIBOR hearkens back to a time when finance operated like a gentlemen’s club — and its leading members behaved honestly. That is a universe away from the current Wall Street culture and behavior.

They take out bets and pay themselves fortunes for doing so, even when they cannot make good on those bets without taxpayer bailouts. They create securities they know are likely to fail, on behalf of clients prepared to bet against those instruments — and then pawn off the same securities to other clients as safe investments.

Now we also know that when they bet on interest rates rising or falling, they stacked the LIBOR deck to nudge rates in the direction that made money. And they left everybody else with the bill.

The dangerous myth of self-regulation

As long as Big Finance will do almost anything to goose its own profits and bonuses, “self-regulation” is a dangerous myth. One wonders whether the reason this deception has been carried off with such apparent disregard of any potential consequences is that the big banks are such large and dependable sources of campaign funds for both parties.

This deplorable state of affairs is profoundly un-American. That is why it should urgently give way to sound law enforcement, which in economic terms means additional government regulation. The American people are already struggling with the aftermath of the ruinous financial crisis. They cannot afford to have their pockets picked by interest-manipulating financial institutions, while regulators look the other way.