Part 1 of a two-part article from the March/April 2021 issue of Dollars & Sense. We will post Part 2 later this week.
By John Summa
Economics textbooks teach you that the London Interbank Offered Rate (known by the acronym “Libor”) is the rate at which big global banks make uncollateralized loans to each other. (An uncollateralized loan is backed solely by the perceived credit-worthiness of the borrower.) For years, Libor was considered a fair and efficient market rate of interest, reflecting money market supply and demand conditions, which gave it legitimacy as a benchmark. It is referenced by a wide range of financial products, including mortgages, student loans, and consumer loans, as well as structured financial products such as mortgage-backed securities and collateralized debt obligations (CDOs). However, in the wake of revelations that surfaced beginning in 2012 that became known as the “Libor rigging scandal,” the world learned that banks were unfairly setting the Libor benchmark at levels that were more profitable for them.
The manipulation of a benchmark interest rate is so abstract that, even if we recognize it as fraudulent behavior, it is hard for members of the general public to understand who was victimized and how much harm was done to them. Was it just the playboys of high finance picking each other’s pockets, or the pockets of their well-to-do clients? Or were they teaming up to pick ours, meaning the bank accounts of average working people? While none of these scenarios are mutually exclusive, my research reveals another dimension of the scandal—that banks may also have been stiffing homeowners by charging inflated Libor rates on their adjustable-rate mortgage loans.
The United Kingdom’s Serious Fraud Office (SFO, analogous to the United States’ Federal Bureau of Investigation), spent seven years looking into suspicions that a number of big banks were colluding to manipulate Libor for their own benefit. The investigation, which ended in November 2019, led to some mid-level traders who were employed by the banks being sent to jail. But it was disappointing to many observers of the scandal that the SFO did not take any further action with the case. When the investigation closed, we lost the opportunity to learn more about exactly what was afoot and how it was done.
One important underreported dimension to the Libor story, which never became part of the SFO’s investigation, is the link between Libor and adjustable-rate mortgage (ARM) loans, many recklessly made to often vulnerable and exploited borrowers in the U.S. mortgage market. The evidence that I amassed as an economic consultant to a Vermont-based independent litigator attempting to bring a class action lawsuit against Bank of America and Wells Fargo was damning enough to cause the banks’ lawyers to agree to discuss a potential settlement offer. Due to technical issues with the class action lawsuit, the case did not move forward. So the data and statistical results never ended up being fully presented in court. However, the Libor research suggests that manipulations designed to raise rates on adjustable-rate mortgages may have unfairly transferred billions of dollars from mortgage borrowers to banks, as well to other related parties involved in facilitating such transactions.
The Market That Was Not a Market and Is Still Not a Market
Libor was created in 1986 to provide uniformity in the pricing of a burgeoning global derivatives market. From its inception, Libor has remained an “argued” price, writes Alexis Stenfors, former UBS derivatives trader and author of Barometer of Fear, a book about the Libor scandal. It is often a “judgement” by banks, he writes, what banks argue the rate ought to be. It is not and never has been driven by actual supply and demand in an actual market.
Prior to the revelations in the Libor rigging scandal, Libor was entirely unregulated. This meant that conditions were in place for banks to abuse rate-setting in the interest of maximizing profits. Today, the Intercontinental Exchange (ICE) Benchmark Administration is responsible for managing the Libor benchmark and the entire process is regulated by the United Kingdom’s Financial Conduct Authority (FCA). Each morning ICE sends the following question to panel banks: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?” [emphasis added]. The problem with this question is that it appears to be irrelevant to how the Libor panel banks actually function today. As Federal Reserve Chair Jerome Powell wrote in a Wall Street Journal opinion piece, “In essence, banks are contributing a daily judgment about something they no longer do.”
Thus, while more governance and oversight by regulators is certainly a good thing, it does little to change the fact that the rates submitted by panel banks are largely not those the banks are actually paying to borrow. So, there is still lots of room for potential tampering. A lawsuit filed in 2019 once again raises questions about manipulation of this important interest rate by banks, for banks.
What Was Learned: “Low-balling” and Other Bank Manipulation of Libor
There were two reported dimensions to the Libor rigging scandal. One was related to Libor “low-balling” by banks (which some Libor panel banks have admitted to doing as part of settlements reached with authorities), which resulted in unfair payments to some holders of derivatives indexed to Libor. This low-balling mainly took place during the early part of the financial crisis, and it reportedly benefited banks as credit-risk concerns mounted. Banks’ artificially lowered Libor rate submissions made these banks seem healthier than they actually were, and this would have buoyed their bank shares and lowered the cost of doing business overall because of lower apparent credit risk. They had to have acted as a collusive pack to make this happen, as is now known from some banks’ own admissions to regulatory authorities as part of settlement deals (see the “Barclays Settlement as Collusion Prototype” sidebar).
For example, on December 18, 2012, UBS settled a Libor-rigging case with the Department of Justice. As part of the settlement, the bank acknowledged that one of its traders had “requested that his counterpart traders at other Contributor Panel banks make requests to their respective Yen LIBOR submitters to contribute a particular LIBOR submission, or to move their submission in a particular direction (i.e., up or down).” UBS also admitted that this “trader made these requests to his counterpart traders at other Contributor Panel banks on many occasions.”
While this is just one example, the same process, assisted by broker “conduits” working with all panel banks, was no doubt at work elsewhere, such as in the setting of the U.S. dollar Libor rate.
For example, economists Connan Andrew Snider and Thomas Youle published an article in the online journal Social Science Research Network that used statistical studies of manipulated submissions driven by bank incentives as evidence of bank collusion to move rates up and down based on shared incentives.
There was also a second dimension to the Libor scandal: Banks’ traders of Libor-indexed derivatives got caught working with the banks’ Libor rate-submitters to manipulate rates higher or lower. These day-to-day machinations worked in accordance with the trading of portfolios of derivatives and was driven by profit-making (and bonus-seeking) objectives. This type of apparently trader-led manipulation, which evidence shows took place as early as 2005, benefited banks’ derivative portfolios, which traders were managing or directing. Fraudulent lowering of Libor by the Libor panel banks, and connivance between bank traders and submitters, would become the basis for lawsuits brought by investors, some of which have been dismissed while others are still working their way through the court system.
While Barclays and some other banks had to pay large fines to settle cases following revelations of wrongdoing in 2012, in the end, these fines were relatively small in relation to what banks typically write off in loan losses each year, which is viewed as a normal cost of doing business. Since then, banks have managed to put the scandal largely behind them and no doubt view this ability to do so as a success, as their annual reports have suggested. And with Libor slated to be discontinued and replaced with another benchmark established by regulators after 2021, this chapter in banker malfeasance will have all but passed.
Part 2 of this article, which we will post later this week, looks at whether there was a third dimension to the Libor rigging scandal that authorities missed.
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).