Practical Dad

What is LIBOR and What’s the Deal?

There's a growing brouhaha in England and heads in the banking sector there have already begun to roll.  It has nothing to do with hookers or rogue traders that spend the company dime on cocaine futures; rather, it pertains to something as innocuous as the financial equivalent of a screw, an interest rate called LIBOR, which like a screw serves as an underpinning to a large portion of the global financial structure.  While the action is in England, the effects are felt here as LIBOR is used in financial instruments in the US and the reality is that there are American banks which contribute to the determination of LIBOR.  Did they participate?

What is LIBOR

When most people think of banks, they think that the institutions are free-standing entities that compete with one another for business with minimal interaction; any additional funding needs can be achieved via working through the Federal Reserve System (although the sense is that things are pretty bad if that's the case).  For the smaller banks, this is par but the larger banks - especially those deemed Too Big To Fail - have daily funding and liquidity needs that outstrip what they have on hand.  These banks consequently interact with one another each day and those with extra will lend to the other institutions at a very small rate, small because these lending institutions expect to have the money back very soon and also because they know with whom they're dealing.  Consequently, the rate that these institutions charge one another is exceptionally low and requires no collateral for the extremely short duration.  LIBOR - London InterBank Operating Rate - is the name of this rate.

LIBOR came about because of a nudge from the British Banking Association in the mid-1980s.  With the introduction of a wide range of new and complex products - adjustable/variable rate mortgages, interest rate swaps, and other goodies - in the early 1980s, it became apparent that there had to be a common rate upon which the various products could be based else for contractual purposes.  Because London continued to be home to a significant part of the global financial community, the BBA pushed the financial community to develop such a uniform rate and LIBOR was born, taking effect in 1986.  Understand that while the name implies a solely British scale, the actual LIBOR rate is determined by the responses by only a handful of banks from the international community and is updated daily.  These daily rates are then used in an immense number of financial contracts occuring globally as the reference point for the payments that pass from one party to the other.  How immense?  The cumulative financial value of the contracts with some input from LIBOR are in the hundreds of trillions of dollars - that's Trillions, with a T.

What's the issue with LIBOR?

The issue with LIBOR, and it's so far claimed the top three executives of Barclays Bank - a major international bank based in Britain - is that it's become clear that the daily rate has been gamed by at least several of the banks.  The member banks are expected to report a particular rate each day based upon their best estimate, but Barclays is the first to have been found to have underreported what their rate would be in order to do favors for other institutions; this means that the true rate of interest is actually higher than the artificially low rates reported as the official LIBOR rate for that day.  The difference is unknown at present and would depend upon how many member banks colluded in the rate reports and to what extent was the level of underreporting.  For each of those days affected, any number of variable rate mortgages and other rate-sensitive contracts, would be consequently affected. 

The CEO of Barclays, Bob Diamond, recently testified before a Parliamentary Committee regarding the LIBOR scandal.  His testimony was Barclays actually was pressured to do so by the Bank of England, the equivalent of the English Fed; but the note to file after the BoE/Barclays conversation not only supports his claim, but unequivocably states that not only were other banks rigging their LIBOR submissions, but that the BoE knew of it and wanted Barclays to fall in line with the other rigging banks.  The old saw is that prisons are full of innocent men and given our present who ya gonna believe environment, there will be questions as to the veracity of the note.  But the damage is done as there's a strong discrediting of the entire financial establishment, profit and regulatory alike.

So long as LIBOR is now under suspicion, there's now a pall over the use of many of these products.  There's a true impact on rate sensitive contracts in the works but not yet signed.  Is this truly the real rate or is it rigged?  Is there some other rate standard that can be used in it's stead and how dependable is it?  There's a potential impact on mortgages as lenders slow down lending to see how this plays out and families waiting for word on whether they will be able to purchase a home.  The monthly nut for the difference of 3/4 of point in a mortgage rate can be in the hundreds of dollars, so what does this do to home sales?   One of the other great losers in this episode are the various non-profit and governmental entities that might engage in interest rate swaps to help control the cost of capital projects.  Will needed infrastructure projects - bridges, sewer treatment plants, road work - be able to move forward or will they have to be shelved?  With Stockton, California now in bankruptcy and other entities - Detroit, Harrisburg, Jefferson County, Alabama - as poster children for fiscal disaster, how will necessary work move forward? 

This is simply for the world moving forward and says nothing about the rate sensitive contracts that are already in place.  Frankly, if I had an interest rate swap and heard this news, I'd pull the paperwork and review it in a much more skeptical light with an eye towards litigation.

Why is this a big deal?

The implications of a rigged baseline reference point are massive.

The LIBOR rate is a global reference point, much as the gram is a standard for determining mass or the gallon for measuring volume.  But unlike the gram and gallon, there is no true governmental oversight for the protection of the LIBOR rate; the English government essentially let the determination of this global standard to an insular financial industries community that put itself ahead of the common good. 

If you want a comparison, suppose that governments failed to inspect and regulate gasoline pumps but let the maintenance and standardization of those pumps fall solely to the oil companies?  What would you think if you were paying for 20 gallons of gas each week but were in reality only getting 17 gallons in your tank?  Would you be angry with Exxon-Mobil or BP for abusing your trust, let alone your wallet?

What would you think if Otis Elevator purposefully used defective materials in the production and installation of elevators? 

What would be your response if you found a roach in your kid's Happy Meal and then found that the local health department had suspended restaurant inspections because they considered the folks at McDonalds to be okey-dokey 100% upright citizens?

When your roller-coaster car went barreling off the rails on that last hair-pin turn, would your last thought - before your brain splattered against the pavement - be to curse the state for not inspecting the ride before it opened?

What would you think if you found that your hoped-for home, in the neighborhood with the school you want for your kid, was suddenly unaffordable because your lender had to adjust the rate on the prospective loan to account for a gamed LIBOR reference rate?  What if they simply became Loan Nazis and said no loan for you! 

These examples don't mean that I have a blanket distrust of business, at least not Otis.  But each of these areas are under public regulation and inspection because there's a long history that demonstrates that companies and individuals can prefer private gain over the common good, even to the point of death.  In each of these industries referenced, there wasn't some uniform inspection and enforcement mechanism simultaneously enacted in a piece of blanket legislation; the regulatory oversight was created on an as-needed basis and that need was usually prompted by some scandal involving death, serious threat to the public welfare or serious financial loss. 

No one has died, but there's damage nonetheless.  The losses put to the public treasury are already in the trillions of dollars and these losses detract from more important uses, let alone the knowledge that we're mortgaging our grandkids' future with the debt.  The failure of the fiduciary component of the financial industry has allowed self-interested bankers to plunder their clients' savings.  The failure of the fiduciary component has allowed the banks to wholesale gamble with their capital, knowing that any failure would be made good by the public trough.  If you aren't certain of this, consider the recent issue regarding JP Morgan Chase's $9 Billion screwup that led to their CEO's appearance before Congress.  While the drama is on in Britain, the problem doesn't lie solely with the English government.  This is a pointed example of what occurs when oversight and regulation ceases and people with signficant incentives to cheat are left to their own devices and it happens in the US just as it does in other western nations.  The US deregulated the financial services industry in the 1990s and the result since then has been an ongoing parade of unethical and sometimes illegal behavior in the time since. 

Planes aren't falling from the skies nor are bridges collapsing as a result of this particular episode.  But the banks have still tampered with the screws that hold the financial structure together and when that structure finally goes, the suffering will be immense.  If you aren't certain, just look at the generational scars left by the Great Depression.  There is an occasional thought that nags at the back of my mind however.  The view of the government's role before the Great Depression is one of benign neglect as it permitted Laissez Faire capitalism to run it's course...

...what would our society be like if government was known to have taken an active role in promoting and facilitating the excesses of the late 1920s?

 

 

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