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%.