There have been lots of ink and bits spilled lately over the manipulation of something called LIBOR – the London Inter-Bank Offered Rate. It may seem as if the only people who need to care about this scandal are bankers and government finance officials. Some of these probably should be checking to make sure that their résumés are up to date; others may get a chance to reflect behind bars. But this truly affects us all.
What is LIBOR? It is a rate (actually a series of rates) based on a survey of British banks of the rate they might charge to lend to other banks. In other words, it is a survey of what amounts to a close-knit little trade group that is based on opinion, not actual loans. Each bank’s offer is published, high and low offers are thrown out, and the resulting average is the rate.
Contracts with a value of more than $360 trillion use LIBOR as a reference point, according to an estimate cited earlier this month in Newsweek. That includes many thousands of contracts in the U.S. It may include your own adjustable-rate mortgage.
But there is no need that the reporters back up their asserted rate with anything substantive, such as actual loans. Given this, what happens if you are trading securities whose values depend on what happens to LIBOR? You have an incentive to fib and talk your friends at other banks into fibbing as well – and fib a good number of them did. We know that this rate-fixing went on as early as 2005, and possibly years earlier at Barclays and allegedly elsewhere as well.
You might think that banks would try to fix the rate upward, but they actually fixed it downward. They did this for two reasons – one internal, the other external. The internal reason was the opportunity to generate trading gains. The external reason was essentially marketing. LIBOR is an indicator of credit risk for banks, so at the height of the credit crisis a lower rate made banks look stronger than they really were. (Remember that the individual submissions are public.) There is evidence that at least one British official sent out emails telling the banks that it would certainly ease fears if LIBOR declined. The trading desk knew that this was going on because in some cases traders were literally sitting next to the people who were reporting the rate. Thus, they made bets on LIBOR falling and made a fortune when it did.
Ironically, while the trading desk was raking in cash, payments on the banks’ own adjustable-rate loans based on LIBOR declined. But no matter. Because of the way the securities that the traders were playing with were structured, a tiny change in LIBOR translated to huge changes in the value of the securities. Losing a bit on a loan is no problem if you make many times that much at the trading desk.
The fundamental problem in all this is that the interest rate on a loan is supposed to be based on the risk of that loan to the lender. If the interest rate was wrong, the pricing of risk was wrong and there were undeserving winners and losers – collateral damage from the point of view of the traders. In this case, it appears that the borrowers were the winners and the lenders were the losers. (Remember that there were many innocent lenders who didn’t have the trading profits to offset their diminished income on their loans.)
It may be harder to generate sympathy for lenders than it would have been for borrowers if the situation were reversed, but this is one more example of the system – which is based on trust – being rigged. If the system is rigged, lenders won’t lend except at a higher rate, borrowers have a harder time acquiring funds to invest, and the recovery is that much slower.