The LIBOR Mess Could Be the Biggest Financial Fraud in History

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http://www.sonecon.com/blog/?p=658

Robert J. Shapiro

If our financial policies were based on recent experience, the debate over government regulation versus self-regulation by Wall Street would be settled. Yet, the refrain that “the big banks know best” remains the default position of most American conservatives and many policymakers. This childlike faith will be tested by the new scandal swirling around some of the most basic interest rates in the global economy, the LIBOR or “London Inter Bank Offered Rates.” This past 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 here 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 J.P. Morgan 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 expect to pay to borrow funds from each other (“Inter Bank”) in the future. Under LIBOR rules, the four highest and four lowest estimates are eliminated, and the average of the rest becomes the official rate. For example, in 2007, the LIBOR rate to borrow three months in the future, in dollars, averaged 5 to 5.5 percent.

LIBOR rates are a very big deal, because they are benchmarks for countless other interest rates. The majority of adjustable rate mortgages, for example, are set at a LIBOR rate plus 2 or 3 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.

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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 lock step. 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 2000–2006, averaging 1.3 percentage points, and the up-and-down movements of the two rates no longer tracked each other.

All of the obvious parties that might have done something about it — the Fed and the SEC, for example, or the Financial Services Authority in Britain — apparently looked the other way. This tolerance for sub rosa 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 $50 to $100 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 percent and 40 percent 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 $1.1 billion and $2.2 billion to the yearly interest paid by American homeowners. And those mortgages account for less than one percent of all of the financial assets and instruments affected by manipulated LIBOR rates.

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1. That's nice. Anyone in jail yet? Had a bonus reduced?