What's Libor and Why Should We Care About It?

The latest financial scandal, involving manipulation of Libor (London Interbank Offered Rate) by the big banks with the apparent complicity of the Bank of England and the U.S. Treasury, has been headline news on the financial pages for the past several days, and is even becoming front page news and the subject of editorials. It’s not easy to find a clear explanation, though. Indeed, most of the stories make it appear that these are just “victimless crimes” in which, if anything, the average Joe and Jane may have actually benefited by receiving slightly lower interest rates on their mortgage and credit cards. But cut through the media spin, and one will find that this is another gigantic, and conscious, rip-off of working people and public institutions by the big banks.

So, what is Libor and how does it work? Libor is supposed to be the average rate at which the world’s biggest banks can borrow from one another. The British Bankers Association, a group of more than 250 banks located in 50 countries, sets Libor.  The BBA sets rates for 15 different loan maturities in 10 different currencies.  There are ten Libor panels, one per currency, and the number of banks on the panels varies (there are 18 banks on the panel for the dollar). The panels do not use actual market rates to estimate Libor -- rather, they estimate the interest rate that they think they would have to pay were they to borrow money from other banks on that day. In other words, they use hypothetical rates -- they make them up. That, of course, is a recipe for rate manipulation.

But wait: there's more.   In calculating the Libor rate for a currency, high and low rate estimates are discarded before averaging the rest.  In the case of the dollar, the four highest and four lowest rate estimates from the 18 banks are discarded, and then the remaining 10 are averaged. The other panels work similarly. The high and low rates are discarded to prevent one or two banks alone from manipulating the rates. What this says about the current Libor scandal is clear: they were all in on it. The rates could not be manipulated without the involvement of many of the big banks.  It is open and shut that there was gross collusion to rig the Libor rates. This is a scandal in its own right: once understood, it exposes the financial industry's claims that it can and should self-regulate, and it exposes the state's (certainly in Britain and the U.S.) that it is tightly monitoring the banks and running the show in the public's interest.

Now, of course the big banks used their rate rigging to their benefit. They rigged Libor up; more frequently they rigged Libor down. The International Swaps and Derivatives Association alone reports that it has written $350 trillion worth of financial contracts tied directly or indirectly to Libor (compare this with "only" $10 trillion in total credit card and mortgage debt, and "only" about $60 trillion in global gross product). It doesn't take a quant to recognize that even a tiny rigging of interest rates can lead to tens or even hundreds of billions of dollars of cumulative gains.

One consequences of Libor interest rate rigging has been to exacerbate the immense harm to local governments, school districts, community colleges, universities, hospitals and others caused by "interest rate swaps".  Protests against interest rate swaps by municipalities, schools, and non-profits around the country have been growing over the past year, but like Libor itself, the way interest rate swaps actually work is rarely explained in the media and hence is not popularly understood.

Here's roughly how "interest rate swaps" work. Investment banks can issue fixed rate bonds at slightly below market rates. Municipalities and other public entities can issue variable rate bonds at slightly below market rates. About a decade ago, big investment banks like Goldman Sachs convinced cash-strapped public entities that issuing and swapping bonds was a "win-win" scenario: the banks would issue fixed rate bonds at less than the market interest rate and swap them for adjustable-rate bonds issued by the public entity (also below market rate). Everybody wins. Except for the contingencies: in most of these deals, the public entities agreed to issue very long-term adjustable-rate bonds  (often 20 years or more), and with interest rates that were adjusted every week or month (making them susceptible to rate-manipulation).  And there were extremely high early termination penalties (often in the tens or even hundreds of millions of dollars). 

Of course, after the contracts were written, interest rates fell to near-zero, leaving the public entities holding the bag paying fixed interest rates several percentage points higher than the near-zero adjustable rates paid by the banks. And they could not get out of their contracts without paying enormous early termination penalties. So rigging Libor rates low added to the liability of the cities, schools, hospitals, etc. -- i.e., added to the siphoning of wealth to the big banks from the working class.

The "interest rate swap" rip-off is an emerging scandal that is getting increased attention in the U.S. The city of Baltimore is suing the banks around it. California's Water Resources Department lost $305 million to Morgan Stanley on these rigged interest rate bets. The state of North Carolina lost $60 million. The small city of Reading Pennsylvania lost $21 million. The San Francisco International Airport lost $22 million. The Bay Area (San Francisco-Oakland) Metropolitan Transit Authority has lost a net $235 million in interest rate swaps. Jefferson County Alabama (the home county of Birmingham) became the biggest municipal bankruptcy on record, and much of its crisis stemmed from losses on interest rate swaps.

Certainly, in the Oakland area, there is considerable ferment around the growing awareness that schools are being closed, bus service cut back, pensions being rewritten, public workers laid off and programs cuts, while the banks continue to haul in hundreds of millions of dollars from these swaps in the Bay Area alone. The Oakland city council last month voted unanimously to terminate all business with Goldman Sachs if it doesn't release the city without early termination penalty -- the issue had been pushed by a reform coalition including clergy, community groups, and some local labor leaders. The faculty and staff unions in the Peralta Community College district (the community college district for Oakland and environs) have organized rallies and forums demanding that Morgan Stanley release them from the interest rate swap without penalty. The West Contra Costa Unified School District (a low-income, predominantly black and Latino area about 10 miles north of Oakland) is suing to be released from an interest rate swap -- like Oakland and the Peralta college district, they long ago paid off the principal (the West Contra Costa fight is being led by a reformist coalition including the local Green Party, the teachers' union, community groups, and others).

The reason Libor hasn't yet generated more anger is that it remains opaque to most people – as we said at the outset, it’s too often presented as "a victimless crime". I hope this piece has helped to make things more intelligible. I think that anger around the Libor rate-rigging rip-off will combine with the already quite pervasive if inchoate anger at the recapitalization of the banks coming at the expense of workers' living standards (wages, jobs, pensions, schools, public services). And it will combine with the anger around student loan debt (and consequent indentured servitude of 36 million U.S. students and former students).

Not another penny for the banks!

Bail out schools and services, end foreclosures!

End the rip-offs – reorganize the financial sector under public control!