We are the 99%

July 15, 2012

LIBOR? What's LIBOR?

Today, instead of deconstructing Jack Kelly or Richard Mellon Scaife's braintrust, we'll start here:
Major American television news outlets are devoting scant coverage to one of the largest banking scandals in history. Regulators are investigating whether major financial institutions have been manipulating the LIBOR, a key interest rate that banks use to borrow money from one another. The British multinational financial institution Barclays has already been fined $450 million for its role in the scandal. Despite the massive scope of the controversy -- LIBOR is "used as a benchmark to set payments on about $800 trillion worth of financial instruments" -- CNN, Fox News, MSNBC, ABC, CBS, and NBC have only spent about 12 minutes combined covering the story during their evening newscasts and opinion programming.
The link in that paragraph leads to an article at The Economist that explains a little more what that LIBOR number is:
The number that the traders were toying with determines the prices that people and corporations around the world pay for loans or receive for their savings. It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year. Yet it turns out to have been flawed.
So what, exactly, is this LIBOR thingie?

The BBA (British Bankers' Association) explains that it:
...stands for 'London InterBank Offered Rate'. It is produced for ten currencies with 15 maturities quoted for each - ranging from overnight to 12 months - thus producing 150 rates each business day.
And how does this happen?
Every contributor bank is asked to base their  [LIBOR] submissions on the following question:

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” Therefore, submissions are based upon the lowest perceived rate at which a bank could go into the London interbank money market and obtain funding in reasonable market size, for a given maturity and currency.

[LIBOR] is not necessarily based on actual transactions, as not all banks will require funds in marketable size each day in each of the currencies/ maturities they quote and so it would not be feasible to create a suite of LIBOR rates if this was a requirement. However, a bank will know what its credit and liquidity risk profile is from rates at which it has dealt and can construct a curve to predict accurately the correct rate for currencies or maturities in which it has not been active.
And so what did Barclays do?

This, from the BBC:
Here is today's statement from the Commodity Futures Trading Commission, the CFTC:

"Barclays….attempted to manipulate and made false reports concerning both benchmark interest rates to benefit the bank's derivatives trading positions by either increasing its profits or minimizing its losses. The conduct occurred regularly and was pervasive."

The CFTC also says that after the start of the credit crunch in August 2007, all the way through to early 2009, Barclays made "artificially low…submissions" about the interest rate it was being forced to pay to borrow to "protect Barclays' reputation from negative market and media perceptions concerning Barclays' financial condition".

This was done, according to the CFTC, "as a result of instructions from Barclays' senior management".

In other words, Barclays was pretending that it could borrow more cheaply than was actually the case, to reassure its owners and creditors that lenders had more confidence in it than was true. [emphasis added]
AY-und:
To put it another way, a tiny difference in the Libor or Euribor rate could determine whether a bank like Barclays - and other banks - would make a profit or a loss on huge derivatives deals. So there was a massive incentive to try and manipulate that rate.
Of course there was.

So what does that mean to everyone else outside of the banking industry?

Take a look at what's happening in Baltimore:
The city sued in August because of Libor's relationship to some of Baltimore's bonds, naming banks on the Libor-setting panel, including Bank of America, Barclays and Citibank.

In the early 2000s, during Martin O'Malley's tenure as mayor, Baltimore issued bonds tied to Libor to raise money for parking infrastructure, water utilities and other projects. To entice investors, the bonds paid a floating interest rate — Libor plus an additional percentage. Such floating rates insulate investors from interest rate swings and inflation.

But they can present problems for municipalities with tight budgets. If interest rates shoot up, a municipality would need to find money by either raising revenue or cutting costs to pay more to the bond investors.

"A typical city just cannot afford that uncertainty. That would be deadly. They just cannot take that risk because they live on a thin margin," said Yuval Bar-Or, an adjunct professor at the Johns Hopkins University's Carey Business School.

In order to protect itself, Baltimore executed a contract with a bank that transferred that uncertainty. The city agreed to pay the bank a fixed interest rate and, in return, the bank agreed to pay the amount the city owed investors on the floating-rate bond.

It's called an interest rate swap. In such an arrangement, if the benchmark rate goes up, the city is protected because the bank foots the bill.

Both the city and the bank should anticipate that the floating rate will remain below the fixed rate that the city pays the bank, so the bank can make money.

But if the benchmark rate is lowered artificially, the city loses more money than it should in the swap transaction.
Which means, of course, that the bank makes more than it should.

More evidence, as if we needed it, that the system is fixed in favor of the 1%.

4 comments:

EdHeath said...

I would bet someone that the Daily Show will cover this in the coming week. Because they have been off for two weeks, they may not get to it Monday night, although they really should.

This is not a story that should only be covered by The Economist or Salon.com (at least ten mentions in the last week), because we don't want only people at the political extremes knowing about it. As Dayvoe points out, the impact trickles down to bond issues from city governments that are at the edge of their finances.

This raises yet another concern, that we (the US) were dependent on the English to raise the alarm and penalize Barclays. It sounds like US banks were co-conspirators, yet you have to wonder how likely it is that any of them will see the inside of a courtroom. We almost need an international banking authority to enforce agreed upon rules and regulations, except that the US would likely never sign onto such an authority (see International Criminal Court and Law of the Sea). But we're OK, we have a Congress strongly interested in closely regulating the activities of our biggest banks (I'll wait for you to stop laughing).

It's funny how in some ways we were better prepared for the financial crisis in 2008 than we were in 1929. Automatic stabilizers (such as unemployment) eased the extent of it, making it the great recession (or lesser depression) instead of Great Depression II (this time it's personal). But the sense of outrage at the greed of bankers putting so many people out of work was diffused by the racism of perhaps as much as 45% of the country being pissed off that a black man was elected President.

The sense of outrage over the collapse has remained muted, being depleted by the (continuing) fight over the stimulus, the fight over health care reform, the fight over the auto bailout, the fight over the CFC, the fight over ... In the thirties there were people who hated FDR, and some bitter divisions. But I think that the wealthy were afraid to fight reformers over the moral high ground. But let's face it, in the eyes of conservatives around the country and who comment on this board, a black man has automatically lost some moral authority just by being uppity enough to speak out out against the wealthy. I suspect that Hilary Clinton would have been challenged on competence (that's so cute a woman would say such things), but a black man faces the attitudes of millions of Americans that blacks are inherently inferior. I think that, as much as anything, has kept the country from fundamentally reforming the financial sector.

Conservative Mountaineer said...

@Ed..

If I understand the issue correctly, Barclays understated their estimation of LIBOR which, in turn, would have resulted in LIBOR being less than what it may have actually been.

Sure, that may have resulted in a propping-up of bank share prices or some other non-provable or non-quantifiable benefit (Who really knows?). LIBOR is an estimation.

The way I read most of the analysis is that banks such as Barclays got hammered by being more forthcoming intially and then said "'Eff it. Why be so honest?"

Seems as though certain US banking officials and regulators (Turbo Tax Timmy, for one) didn't make a big stink about the issue. Why is it a big issue now? (Slow Summer news season... Oooooo.. those big bad bankers!)

Finally, how is what happened a bad thing for borrowers? It's not.

I haven't had much of an opportunity to delve into this in detail nor do I expect to have an opportunity.

EdHeath said...

I dunno, CM, the big fine is what is making it an issue now. It was quite a while ago that this was apparently going on (2005 - 2009) and our regulators (as you say, Geitner among them) did not utter a peep at the time. All our regulators and economic advisers to *both* Bush and Obama have been way too tied into Wall Street. Unfortunately, a lot of economists with strong academic credentials have been invited to and accepted seats on boards of directors of large banks. It makes it hard for them to give good advise about regulations.

I have to confess I don't know much about LIBOR myself, mostly only what I read. But as to why it might be bad for borrowers (or investors), I guess it was one more piece of misinformation for consumers, besides the toxic mortgage bundles and other lies banks were telling. But I am not surprised that you think consumers should be kept in the dark, so as to be fleeced that much more successfully. I guess you think accounting rules are for pussies. That would be why you get the the big bucks, yeah?

EdHeath said...

The Daily Show covered LIBOR on Wednesday. In a light way.