Why You Should Care About LIBOR

Jul 06 2012 Published by under Featured News

So, what is the big deal about LIBOR? This is a high-level overview of what the scandal is and why you should care about it.

LIBOR is an interest rate (London InterBank Offered Rate), one of the key rates that loans in this country are tied to. Thus, when it goes up and down, it affects the amount of interest that you and I pay on mortgages, car loans, and revolving credit. Worldwide, over 500 trillion dollars in financial valuations are based on LIBOR.

LIBOR is a composite number. Every working day, banks send to Thomson Reuters their estimate of what it would cost their banks to borrow money. The high and low numbers are thrown out, the middle 50% is averaged, and voila: that day’s LIBOR.

Barclay’s bank admitted to manipulating LIBOR rates (and RBS, UBS, Deutsche Bank, and Credit Suisse are suspected of colluding) in two ways.

First, it admitted to overstating its rates from 2005 to 2007, when the market was strong.

Second, it admitted to underreporting rates in 2008 when the market was falling.

Overstating rates has two results. First, people pay more interest to banks. Over 500 trillion dollars is connected to LIBOR. Suppose that just one billion in loans are issued on a given day, a day on which the interest rate was bumped up by two basis points (say from 4.98% to 5.00%). It sounds like an insignificant change, but multiply that times a billion, and you get a flat increase of two million dollars extra the banks booked that day. Add some compounding interest over eight or ten years, and you’re talking real money. Of course, LIBOR manipulation did not happen in a vacuum. Consider that other manipulations of the banks caused a bubble in real estate prices. If you bought a home near the peak of the bubble, you could be paying an artificially inflated interest rate on an artificially overpriced home.

Second, the bank could bet that rates would increase before submitting the inflated rate, thus causing the bank to win its bet. Where there is a winner of a bet, there is also a loser. The loser may be something in your 401(k). Thus, the bank cheated to win money from you (and millions of others).

The problem with underreporting interest rates is subtler. Don’t lower rates mean we paid less interest on loans that day? Isn’t that good? Yes, that aspect did benefit people who closed loans on those days, but there is a larger impact that is bad.

Interest rates (in fact any kind of rates of return) are tied to perceived risk. For a bank, that means that if it is perceived as risky (overleveraged, too much worthless crap on its balance sheet, too little cash, etc.), it has to pay more to borrow money. The higher the rate, the more unstable that bank looks to other banks. (That is why the borrowing rates of European countries are so much in the news now—higher rates reflect perceived riskiness)

Barclay’s reported artificially low rates during the market meltdown. By reporting lower rates, it was in effect saying that other banks didn’t see any problem with it. Multiply this times other banks, and you get a distorted picture of the whole financial industry. This sent an artificial message to governments of the world that they didn’t need to step in and take more drastic measures to stabilize the financial industry. Or alternatively, the governments also knew that the rates were artificial, and the low rates were meant to reassure the public that the financial industry was more stable than it actually was. Either way, it affected how the world handled the problem.

Consider that from 1929 to 1932, the government believed (or acted as if) the Depression was much less serious than it was. The President asked for moderate adjustments rather than demand drastic changes.  The grossly inadequate response escalated the Depression instead of reducing it.

If the world’s response to the current financial crisis was inadequate, there may be a second bigger meltdown in our future. Many believe we are absolutely headed that way because we have never acknowledged the scope of the real problem and taken the more drastic steps needed to avert disaster. Of course in 1929, banks were not flooding the world with false information about their stability.

Why am I talking about perceived riskiness instead of actual riskiness? Because the economy is a collective abstraction. Its survival depends on the willingness of all of us to trust it. It only works because we believe it works. When trust is lost, participants stop believing, and you get things like runs on banks. With every new revelation of how banks swindled their own clients, cheated municipalities, lied, coerced people, rigged bids, and got the taxpayers to clean up after them,  it becomes harder and harder to accept even a revised system with these banks as the centerpiece. This is why so many people have flocked to gold investing, although gold is just one more thing that has value because we collectively decided it did. You can’t eat it, wear it, or protect yourself with it.

As more scandals emerge showing corruption throughout the financial system, the job of fixing the system looks that much more daunting, even with full political approval. The fact that we don’t have the political will because the financial system controls the political system as well does not bode well for us.

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