Explainer: Why the LIBOR scandal is a bigger deal than JPMorgan

July 5, 2012

Last week, Barclay's admitted to rigging the London InterBank Offered Rate (LIBOR) and agreed to pay U.S. and British regulators $450 million dollars in penalties to settle the case. Then the heads began to roll: On Tuesday, its CEO, Bob Diamond, and COO Jerry del Missier resigned, and yesterday Diamond told a British parliamentary inquiry that regulators in Washington and London alike were complicit in his manipulations.

This is a big deal. Remember that JP Morgan scandal a few months back? That was mostly JP Morgan hurting itself. The LIBOR scandal was Barclay's making money by hurting you.

In the simplest terms, LIBOR is the average interest rate which banks in London are charging each other for borrowing. It's calculated by Thomson Reuters — the parent company of the Reuters news agency — for the British Banking Association (BBA), a trade association of banks and financial services companies. The actual process of determining the rates is dead simple, and in fact conducted by only two people. Donald MacKenzie, a sociology professor at the University of Edinburgh, described the process in the London Review of Books:

The calculation of Libor is coordinated by just two people, who work in an unremarkable open-plan office in London’s Docklands. I watched the process, which seemed utterly routine, a couple of years ago. Just after 11 a.m. on every weekday that’s not a bank holiday, traders at leading banks send in their estimates of the interest rates at which their banks could borrow money. They do this electronically, but sometimes the co-ordinators make a phone call to a bank that hasn’t sent in its estimates, and if the latter seem implausible – typos, for example, are fairly common – they’re checked, also with a quick call: ‘Hi there, is the Kiwi chap [provider of the estimates for borrowing New Zealand dollars] about? … Bit of a spread on the two month. Everyone else is coming in a good bit under that.’

 

A simple computer program discards the lowest quarter and highest quarter of the estimates, and calculates the average of the remainder. The result is that day’s Libor. The calculation is repeated for each of ten currencies and 15 loan durations (from overnight to 12 months), so 150 Libors are published daily: overnight sterling Libor, one-week euro Libor, one-month yen Libor, three-month US dollar Libor and so on.

So why does everyone care about a handful of numbers that a couple guys in an office crunch every day before lunch? The simple answer is that $360 trillion in assets worldwide are indexed to LIBOR, and much of those assets are consumer debt instruments like mortgages, car loans and credit card loans.

In the United States, the two biggest indices for adjustable rate mortgages and other consumer debt are the prime rate (that is, the rate banks charge favored or "prime" consumers) and LIBOR, with the latter particularly popular for subprime loans. A study from Mark Schweitzer and Guhan Venkatu at the Cleveland Fed looked at survey data in Ohio and found that by 2008, almost 60 percent of prime adjustable rate mortgages, and nearly 100 percent of subprime ones, were indexed to LIBOR:

That means that when LIBOR rises, so do the prices ordinary consumers pay to, say, get a mortgage. Which means a bank that mucks with the LIBOR rate isn't just playing around with esoteric derivatives that will only affect other traders: They're playing with the real economy that most of us participate in every day.

So how did the manipulations by Barclay's affect this rate? First, from 2005 and 2007, the bank allegedly varied the rates it reported to the BBA and Thomson Reuters so as to improve its margins on internal trades. For example, it could have placed bets that the LIBOR rate would increase, and then reported artificially high rates which in turn artificially increased the LIBOR averages, so that the bets were likelier to pay off. This not only screwed the investors on the other side of the trade, but bumped up mortgage rates  however infinitesimally  for consumers even when the risk of the loans hadn't changed at all.

Second, in late 2008 Barclay's  and, Diamond alleges, other banks  apparently low-balled the rates they reported for LIBOR averaging so as to make the banks' finances look more stable than they were. The idea was to put out a false image of stability to prevent market panic and stave off calls for additional regulation or even nationalization, a solution that looked increasingly likely during the height of the financial crisis. The direct effect for consumers here was to make loans cheaper, but the indirect effect, or the intended one at least, was to lessen chances of government action against the banks. So the banks manipulating LIBOR weren't just messing with peoples' finances  they were trying to mess with the peoples' laws.

The LIBOR scandal, then, is something more insidious than the multibillion-dollar failed trade that got JPMorgan into so much hot water. Unlike the assets JPMorgan was trading on, the LIBOR rate has real consequences for average consumers, and its manipulation could hurt your typical mortgage-holder, however minimally.

Further, at least some LIBOR manipulation was an attempt to manipulate government policy by changing the very data that regulators use to make decisions. If the LIBOR games prevented governments from pursuing policies that could have made the financial system more stable, the main victims, again, are ordinary consumers.

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Brad Plumer | July 5, 2012