If our financial policies were based on recent experience, the debate over government regulation versus self-regulation by Wall Street would be settled. Yet, the refrain that the big banks know best remains the default position of most American conservatives and many policymakers. This childlike faith will be tested by the new scandal swirling around some of the most basic interest rates in the global economy, the LIBOR or London Inter Bank Offered Rates. This past week, Barclays Bank admitted that it secretly manipulated LIBOR rates for years, all to pad its own bottom line. And Barclays is not some lone, bad apple. Investigators here as well as in London, Brussels and Tokyo are hard at work looking into reports of similar manipulation by other big players, including Citigroup, Deutsche Bank and J.P. Morgan Chase. This could well turn into the largest consumer fraud ever seen.
It will take months for the general public to catch up or catch on to what this latest scandal is about. It starts with one basic fact: LIBOR interest rates are not set by the supply and demand for credit, like many other rates. Instead, every morning, representatives of the 18 largest Western banks report on what they expect to pay to borrow funds from each other (Inter Bank) in the future. Under LIBOR rules, the four highest and four lowest estimates are eliminated, and the average of the rest becomes the official rate. For example, in 2007, the LIBOR rate to borrow three months in the future, in dollars, averaged 5 to 5.5 percent.
LIBOR rates are a very big deal, because they are benchmarks for countless other interest rates. The majority of adjustable rate mortgages, for example, are set at a LIBOR rate plus 2 or 3 percentage points. So are millions of student loans, auto loans, and credit card finance charges. LIBOR rates also are used to set or reset small business loans, futures contracts, and interest rate swaps. All told, an astonishing $360 trillion in loans around the world are indexed to LIBOR. That is more than five times the value of the worlds entire GDP this year.
One reason that LIBOR has such a far reach is that there are numerous LIBOR rates for different purposes. Each rate has a time frame rates for loans one day from now; one month, three months and six months out; one year, five years and ten years from now, and so on. There are 15 such time frames, all told. In addition, separate LIBOR rates also are provided for dollars, Euros, yen, and seven other currencies. The integrity of these LIBOR rates, however, depends entirely on the honesty of banks reporting the rates they actually would to expect to pay. Inevitably, we got what we should have expected.
So, when Barclays (and almost certainly others as well) had investments that paid off, or simply paid off more, when interest rates rose, it simply reported a higher figure to LIBOR in order to nudge up the average. And that usually led to higher interest rates for millions of other businesses and people with loans indexed to the LIBOR. Sometimes, it worked the other way. In late 2008, Barclays (and probably others) low-balled the rates they reported for LIBOR averaging. The purpose was to make themselves look sounder than they actually were, since they expected to borrow at low rates. They presumably figured that might reassure their shareholders and perhaps even dampen public demands for tighter regulation.
For several years, academics and a number of market followers warned that something funny was going on with LIBOR. The evidence was not hard to find. For example, the spread or difference between U.S. Treasury rates and LIBOR rates for loans of the same time frame began to widen. From 2000 to 2006, LIBOR rates averaged one-quarter of one percentage point above Treasury rates, and the two rates moved up and down together in lock step. In 2007, however, that spread more than doubled to nearly two-thirds of a percentage point, and their movements up and down did not track each other so closely. By 2008, the difference in the rates was five times what it was in 20002006, averaging 1.3 percentage points, and the up-and-down movements of the two rates no longer tracked each other.
All of the obvious parties that might have done something about it the Fed and the SEC, for example, or the Financial Services Authority in Britain apparently looked the other way. This tolerance for sub rosa interest rate manipulation has cost millions of ordinary Americans and Europeans a great deal of money. Early analysis suggests that for several years, the LIBOR was off by an average of 30 to 40 basis points. (A hundred basis points equal one percentage point in an interest rate.) That is enough, for example, to add $300 to $400 to the annual cost of a $100,000 loan.
In 2007 and 2008, Americans held $11.1 trillion in outstanding residential mortgage debt. At the time, between 30 percent and 40 percent of that debt carried adjustable rates. If the bankers manipulations of the LIBOR was responsible for raising LIBOR rates by just 20 basis points in that period, their shenanigans added between $6.6 billion and $8.9 billion to the yearly interest paid by American homeowners. And those mortgages account for less than one percent of all of the financial assets and instruments affected by manipulated LIBOR rates.
LIBOR hearkens back to a time when finance operated like a gentlemens club, and its leading members behaved honestly. That is a universe away from the current Wall Street culture and behavior. They take out bets and pay themselves fortunes for doing so, even when they cannot make good on those bets without taxpayer bailouts. They create securities they know are likely to fail, on behalf of clients prepared to bet against those instruments and then pawn off the same securities on other clients as safe investments. And now, we also know that when they bet on interest rates rising or falling, they stacked the LIBOR deck to nudge rates in the direction that made money. And they left everybody else with the bill.
So long as big finance will do almost anything to goose its own profits and bonuses, self-regulation is a dangerous myth. It should give way to sound law enforcement, which in economic terms is government regulation.