Part 2 of a two-part article from the March/April 2021 issue of Dollars & Sense . Find Part 1 here.
By John Summa
Was There a Third Dimension to Libor Rigging That Authorities Missed?
One question that remains unanswered and got little press attention in the reporting of the Libor bank scandal involves reported patterns of unjustified upward movement of the U.S. Libor rate at the end of each month, prior to the subprime mortgage loan crisis that began to roil markets in mid-to-late 2007. Remember, Libor is the benchmark for a whole host of interest rates that affect consumers, especially mortgages. Testimony by traders during investigations and news reports revealed that Libor manipulation could have dated back to as far as 1991. For example, did banks try to profit from setting Libor rates higher ahead of the resetting of adjustable-rate mortgage (ARM) loans using month-end Libor rates. Such rate adjustments would have produced more interest income on a whale-size book of Libor-indexed ARM loans (see figure below) that all banks had a stake in, along with other Libor-indexed loans and consumer credit products. In other words, did banks act as a “pack” given their common stake in mortgage-loan resets at the end of each month? And, if so, was this kind of collusion anything new?
Surging ARM first resets can be seen beginning in 2003 and peaking in 2007. In 2004–2007 an estimated total of at least $1 trillion dollars in loans went through their first resets. First resets typically occur after two years of a fixed-rate period have been applied to the loan. A new rate is then calculated based on a reference rate, such as U.S. dollar six-month Libor. Did banks nudge rates higher to extract more interest income from the estimated $1 trillion of adjustable-rate loans as they reset?
Answers to these questions will probably never be known definitively. The investigations of Libor-fixing were inadequate to begin with and were ended without ever fully exposing the inner workings of the guilty banks involved. The premature end to investigations means no bank was caught red-handed. Yet, as I discovered in my own research, bank fingerprints are all over Libor rates indexed to trillions of dollars in residential mortgage loans. The investigations I conducted as an economic consultant to a Vermont-based independent litigator bringing a class action case against Wells Fargo and Bank of America produced strong evidence of banks’ guilt in rigging Libor at month-end, timed to increase profits from adjustable-rate mortgages.
The results of my research I believe convincingly show that banks managed to set higher Libor rates ahead of the resetting of trillions of dollars in mortgages. We know the banks had a motive for such malfeasance. We also know they had the opportunity—and they had the means. Finally, there is very compelling circumstantial evidence that such a crime was committed: The fluctuations that I discovered in the Libor rates used to reset adjustable-rate mortgages appear very fishy indeed. Had there been a full investigation into potential wrongdoing by banks, we could have learned a lot more about such machinations—and banks’ modus operandi.
Statistical Evidence Suggests Libor Rates Were Manipulated Higher at Month-End
As an economic consultant on the class action case mentioned above, I conducted several studies into the potential for banks to rig Libor rates higher to extract more interest income from accumulating ARM loans in the banking system, which were increasingly making up residential home mortgage loans. I examined the period of January 2004 through August 2007 for evidence of anomalous (that is, not warranted by market conditions and thus suspicious) behavior of the U.S. dollar six-month Libor rates—interest rates widely used to price ARMs at month-end resets, as specified in loan contracts. The potential for extra profits for banks could have been in the billions of dollars.
The results of my statistical tests found a significant Libor upward bias—rates higher than they should have been—just ahead of the monthly resetting of hundreds of billions of dollars’ worth of mortgage loans in the period of January 2004 through August 2007. For example, in one of my tests, the second-to-last business day of the calendar month (the day used to reprice most conventional ARM loans) had a pronounced increase of 54 basis point during the period I was examining—about half a percentage point of total extra rate charges applied to millions of resetting loans during the same period. (A basis point, as a measure of an interest rate, is one one-hundredth of one percent.)
As can be seen in Figure 2, this is a statistically significant anomalous movement in Libor relative to a baseline CMT (constant maturity treasury rate). In other words, the Libor rate was out of line with comparable market rates, that is—inexplicably high. (“T-1” on the chart indicates one business day before the end of the calendar month, and “T-0” is the last business day of the month. Both days are used for repricing most ARM loans.) The test results indicate that rates were bumped up on or ahead of dates for resetting interest rates for adjustable-rate loans. While it is hard to quantify exactly how much homeowners were overcharged, it is easy to see that loans linked to Libor that were reset in this period would have been relatively overpriced, given that higher rates were applied to them.
This unexplained rise in Libor relative to the baseline CMT rate is pronounced. Yet there is no explanation for such a deviation in Libor rates compared to other similar market rates. Meanwhile, immediately following the month-end reset, tests showed a significant drop in the Libor rate, indicating a correction back toward a non-biased level (see Figures 2 and 3). Further tests revealed Libor itself was on average set higher in the period ahead of reset compared with the period following reset. While the tests don’t prove that banks manipulated Libor higher, they do provide additional statistical evidence of possible collusion by banks in raising Libor at month-end in the period prior to the crisis.
Figure 3 shows that the first day of each new calendar month has a pronounced negative net change in the study period (-28.8). This is a statistically significant anomalous movement in Libor relative to a baseline CMT rate—again, in other words, something fishy is going on compared to what you’d expect. “T+1” indicates one business day after each month-end reset. The data suggest that while the rates rose just before the resets, they were later dropped one business day after the resets. Boosting Libor rates just ahead of, or on, ARM reset days and then dropping Libor quickly, may have enabled banks to maximize the spread between interest received from homeowners with ARM loans and interest paid to investors in bank originated mortgage-backed securities embedded with ARM loans.
Did Month-End Libor Hikes Overprice ARM Loan Resets?
Prior to the onset of the 2008 subprime crisis, large volumes of adjustable-rate mortgages were made by both U.S. banks and mortgage companies. These loans have different terms, but most were indexed to the U.S. dollar, six-month term Libor (others were indexed to the U.S. CMT rate). The U.S. dollar Libor rate is quoted daily and is used to determine interest rates on ARM loans that are resetting at specified intervals, such as every six months, after an initial period where a lower teaser rate was offered. According to Thomson Financial, the top underwriters of ARM loans
before September 2008 were Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America. Three of these banks were Libor panel banks—Citigroup, Deutsche Bank, and Bank of America.
The amount of ARM loans, along with a growing number of them resetting monthly and indexed to Libor, in the period leading up to the start of the global financial crisis, suggest there might have been a shared incentive to move U.S. dollar Libor rates above where they should have been in relation to the Treasury market or other indicators of the price of short-term funding. According to data published by the Federal Housing Finance Agency, total outstanding conventional mortgages reached just over $10.5 trillion by 2007, with conventional (non-subprime) ARM loans at approximately $3.5 trillion. Most of these loans were originated in the years 2002–2006.
Meanwhile, during the same period, according to the Federal Reserve Bank of St. Louis, “there were more than 3 million subprime mortgage loans originated [per year]… [and] among them, more than 45% were ARMs.” Assuming an average of $220,000 per mortgage, approximately $300 billion in subprime ARM loans were made each year. This would put banks’ total ARM (prime and subprime) loan “book” as of 2007 at about $5 trillion dollars.
But how, exactly, would the pattern identified in the statistical tests noted above have benefited banks given this loan book? Most of these loans were being charged Libor on an adjusting basis using month-end Libor rates—set by many of the same banks who received interest from ARM loans. The simple fact that the banking system thrives on interest received from its assets (loans), and therefore more interest from higher-than-justified Libor rates on trillions of dollars in ARM mortgage and other Libor-indexed loans, just might be enough of a benefit to entice banks to get in on the take. In addition to the mortgage loans indexed to Libor, trillions of dollars in student loans and other consumer loans were also similarly indexed.
As was made clear in a complaint filed in the United States District Court for the Southern District of New York on October 4, 2012,
Defendants [Libor panel banks] and their co-conspirators engaged in a continuing agreement, understanding, or conspiracy in restraint of trade to artificially fix, maintain, increase and stabilize six (6) month USD LIBOR at or around the first business day of each month and thus maximize their profits and rates of return on LIBOR-Based Instruments owned, sold and traded by them.
Banks off the Hook: Still No Definitive Answers
With the official end, in late 2019, of the investigations in the Libor manipulation scandal, we will perhaps never conclusively know if senior bank officials and managers were colluding to game interest rates to their advantage ahead of ARM loan resets. But the potential space for action and incentive for multibillion-dollar transfers vis-à-vis interest payments from consumers to banks were there. And the gains would not have been inconsequential.
For example, for each $1 billion in Libor-indexed loans, one extra basis point (one one-hundredth of one percent) submitted by Libor panel banks would have added $100,000 annually in income. While it is not possible to put a precise number on extra profits that might have accrued to banks, it is not too hard to see how much money is potentially involved regarding extra profits. Given that the ARM loans subject to rate inflation totaled nearly $5 trillion dollars, artificially higher Libor rates applied to first and subsequent resets during the 2004–2007 study period would have led to substantial increases in interest income accruing to banks. Just two basis points in extra interest charges on $5 trillion dollars of ARM loans would have generated over $1 billion annually in additional interest income for banks. This is just from ARM loans. The banks had trillions of dollars in other consumer loans linked to Libor. When a former top bank executive source for this article informed a very senior officer currently at a large bank about my data, the banker responded by saying that “banks were probably trying to jack up the rates so that they would be paid more.” Cynical comments like this from well-placed insiders suggest it is hardly surprising that wrongdoing in the upper echelons of banking takes place, and that it is to be expected. Indeed, my statistical results indicated that the chance of Libor rates moving higher on loan reset dates had less than a 1% likelihood of happening by random chance. It was more likely that bankers’ hands were tipping the scales—and overcharging millions of consumers who ended up paying billions of dollars more to banks in the form of higher interest payments.
Until more transparency is imposed on banks, along with eliminating mechanisms for their continued collusion, the public can expect to see more banker misbehavior in the future.
JOHN SUMMA is an independent researcher, author, and economist. He has taught economics since 1989, most recently at the University of Vermont (2009–2017). He is currently working on a book about his teaching experience at the University of Vermont (chronicled at his blog, DeadEndEconomics.com), titled Class Canceled: Silencing a Lone Voice of Dissent. He can be reached by sending an email to LiborRiggingTips@JohnSumma.com.
SOURCES: Alexis Stenfors, Barometer of Fear: An Insider’s Account of Rogue Trading and the Greatest Banking Scandal in History, (Zed Press, 2017); Matt Taibbi, “Banks Sued for Libor Collusion—Again!” Rolling Stone, July 26, 2019 (rollingstone.com); David Enrich, The Spider Network: How a Math Genius and a Gang of Scheming Bankers Pulled Off One of the Greatest Scams in History (Harper Collins, 2017); Black Knight, Inc., Mortgage Monitor Report, November 2017 (blackknightinc.com); United States Department of Justice, Criminal Division, Fraud Section and UBS AG, “Statement of Facts,” December 18, 2012 (justice.gov); Connan Andrew Snider and Thomas Youle, “Does the LIBOR Reflect Banks’ Borrowing Costs?” Social Science Research Network, April 2, 2010 (ssrn.com); Caroline Binham, “US Woman Takes on Banks Over Libor,” Financial Times, October 15, 2012 (ft.com); Halah Touryalai, “Banks Rigged Libor To Inflate Adjustable-Rate Mortgages: Lawsuit,” Forbes, October 15, 2012 (forbes.com); Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson, “The Origins of the Financial Crisis,” Fixing Finance Series—Paper 3, The Brookings Institution, November 2008 (brookings.edu); Federal Housing Finance Agency, “Residential Mortgage Debt Outstanding—Enterprise Share, 1990–2010” (fhfa.gov); Yuliya Demyanyk and Yadav K. Gopalan, “Subprime ARMs: Popular Loans, Poor Performance,” Federal Reserve Bank of St. Louis, April 1, 2017 (stlouisfed.gov). Liam Vaughan “UBS Gave Out ‘Instruction Manual on Fixing Libor,’ Hayes Said,” Bloomberg News, June 18, 2015 (bloomberg.com); Jerome Powell and J. Christopher Giancarlo, “How to Fix Libor Pains,” Wall Street Journal, August 3, 2017 (wsj.com); Liam Vaughan, Gavin Finch, and Jesse Westbrook, “Life as LIBOR Traders Knew It Seen as Abusive,” Bloomberg News, March 15, 2011 (bloomberg.com); Jamie Dunkley and Harry Wilson, “UBS accused of manipulating LIBOR,” The Telegraph, March 15, 2011 (telegraph.com.uk); Sharon E. Foster, “LIBOR Manipulation and Antitrust Allegation,” DePaul Business and Commercial Law Journal (Vol 11, Issue 3, 2011); Annie Bell Adams, et al. v. Bank of America, et al., The United States District Court for the Southern District of New York, October 4, 2012.
DATA SOURCES: The Federal Reserve Board (federalreserve.gov); The Federal Reserve of St. Louis Economic Data (FRED database, fred.stlouisfed.org); ICE Libor (theice.com/iba/libor); Black Knight, Inc. (blackknightinc.com); Mortgage-X Mortgage Information Services (mortgage-x.com); Federal Housing Finance Agency (fhfa.gov).