For those of you who don’t follow banking industry news, we are about to enter another banking related shitstorm. The short version is that a large group of banks colluded to steal very small amounts of money from basically every person on Earth for about five years. The money siphoned off from consumers is estimated to be in the billions of dollars. This latest in a long line of banking and finance scandals is not anticipated to send the “Global” Economy (which mostly means the OCED economies) into a downward spiral, but I think there are good reasons why USians (among others) should still care.
First by way of background for those unfamiliar with how interest rates are set, LIBOR is the London InterBank Offer Rate. [Wiki] Its the interest rate banks charge one another typically for short term borrowing. LIBOR is relevant to the rest of us because its rate is used as the “base rate” in many other types of loans. The idea is that the rate that banks would charge each other is a cheapest market rate because banks are so creditworthy (HA!), so the rates of all other borrowers can be adjusted based this lowest market rate. For a example a floating rate mortgage may require that the homeowner pay LIBOR plus 2 percent or a credit card may charge LIBOR plus 8 percent. If banks lend to one another at 1 percent then the homeowner pays 3 percent and the credit card borrower pays 9 percent.
Something like $800 trillion – no that is not a typo, I do mean *T*rillion – dollars in assets are affected by LIBOR. [The Economist]
So what happened? Well, what always happens when you give a small number of people unfettered control over the reins of our economy? COLLUSION! A bunch of traders allegedly got together and said…Hey! If we knew what the LIBOR rate was going to be tomorrow we could trade on that information and make enormous amounts of money! And then they realized…oh wait…our friends over there at the other table are the ones who tell the people who calculate LIBOR what the rates are. Hey, you guys want a cup of coffee?
Seriously, they bribed them with coffee. [UK Government's Complaint - PDF]
(Okay, there was probably more than coffee involved, but I like the hyperbole.)
The full consequences of this fraud may never really be known. But as economist Robert Shapiro explains:
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 $50 to $100 to the monthly 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 $1.1 billion and $2.2 billion to the yearly interest paid by American homeowners.
[Shapiro's Blog via an MSNBC article]
Given that consumers will likely never see that money again why should we care? Because there is something we can do to protect consumers going forward. While many of us would prefer wholesale change to our political and economic solutions, I think incremental change is still worth pursuing. In the US, I think that means we need to defend (politically) the financial regulation we have in place from attempts by “free-market” asshats to undermine its effectiveness and we need to work to extend oversight of financial institutions. One thing we’ve learned from recent history is that financial institutions have extraordinary reach, the ability to defraud substantial numbers of people, and no real fear that their fraud will ever be detected.
To be completely partisan for a second, the Republican party seems determined to keep it that way. Recently, the House voted to “defund” implementation of Dodd-Frank. [The Hill.] Since the Republicans regained the House in 2010, they have systematically reduced the ability of our regulatory agencies to police the financial markets by repeatedly cutting their budgets [New York Times Editorial]. Now Romney is running on a platform that includes the repeal of Dodd-Frank - or at least parts of it…which parts he’s not ready to talk about yet…but it will include the parts that are “unnecessary.” [Bloomberg]
Can you guess whose interests he’ll be considering when making the determination of what parts are “necessary”?
*raises hand* Fixing the way LIBOR is calculated, good. Keeping Dodd Frank? Bad. Everyone I’ve ever talked to who actually knows what they’re talking about (and I’ve spoken to a security regulations expert and an economist) say Dodd Frank is a terrible piece of legislation. Basically it was an amalgamation of a lot of pet projects that got thrown in and pushed forward after the last financial crisis, resulting in confusing and over-complicated regulation that doesn’t do a whole lot to actually protect the public and does do a whole lot to raise business costs immensely.
Don’t get me wrong, I can’t stand The Rominee (anti-immigrant, anti-gay, anti-healthcare, anti-anything-else-I-think-is-worth-supporting). But repealing Dodd Frank is not the issue I’d rake him over the coals for.
Well, as both a securities law expert and an economist (Woohoo day job), I’m going to have to say your experts are wrong. Don’t get me wrong…Dodd-Frank has some stupid shit in it but the over arching ideas – regulating systemic risk and increasing oversight of derivative transactions are critical. And every piece of securities legislation passed in the last 100 years has experienced the same backlash from some economists and pundits. I think you should take the time to read the Congressional hearing transcripts and talk to a broader range of experts before declaring Dodd-Frank a bad law.
Is there any possibility that people with mortgages affected by this could file a class action law suit against the banks?
@Andy,
Yes and no. I do think class actions are likely to be filed but two things will limit the recovery of private plaintiffs. First, courts hate class actions and in the last few years they’ve gone to some extraordinary lengths to make class certification difficult. Second, recovery in consumer class actions is becoming less valuable for plaintiffs as companies agree to pay large “nominal” compensation (which sets the $$ received by the plaintiff’s attorneys) but that compensation takes a form that isn’t useful to the consumers who were harmed (like coupons for a discount on services…from the same company that ripped you off). And courts are blessing these types of settlements. So basically, I don’t think its going to help consumers directly.
On the other hand, cities may have more luck. The interest cities had to pay on their bonds was also set in many cases by reference to LIBOR, so cities and states paid more in interest than they had to. In many cases they used these same banks as the underwriters for their bond transactions. Given the large sums involved, I would guess that those cases will be aggressively litigated and settled for more than 10% off your next bond offering.
Still, there are some indications that people who have a LIBOR indexed mortgage *may* (and Im really stressing the may here) be able to void their mortgage if their mortgage is with one of the banks that manipulated the LIBOR and the mortgage was entered into during the periods in which LIBOR was artificially inflated. But to do that a LOT more facts are going to have to come out about who, what, when, and how much.
The other issue with class actions: it’s not not clear whether it will be possible for U.S. consumers who had loans with U.S. banks to bring a suit against foreign banks that distorted market rates but with which they did not directly do business. There’s likely to be some interesting legal questions both with respect to jurisdiction and with respect to how direct a connection is necessary between the actions of specific banks and the loss any given consumer suffered.
The Economist also noted in its coverage this week that there are questions about the integrity of the TIBOR (Tokyo InterBank Offer Rates), which may have been affected by similar manipulations. There’s a lot more to come in this scandal, I think.
Wow, I had no idea that interest rates were calculated like that. So basically (since it was calculated as an average of the bids from the banks) all the major banks had the ability to manipulate the rate in the direction that would maximize their profit?
Using this as a reference rate for loans from these same banks seem ridiculously open to abuse.
How could this have been going on for years without action?
I think I have had a hard time understanding this scandal because I couldn’t wrap my brain around the idea that the banks would be allowed so much control over any interest rate. It’s like governments still don’t understand how pervasive the banking industry is in their constituents’ day-to-day lives—or governments just default to acting in the short-term interest of the banks.
But Doc – it was a market – and markets are magic bullets that somehow defy human greed. Or something, something, you hate freedom!
(Nevermind the economists have been saying for centuries that markets don’t work well under certain conditions – like when there are a small number of participants…)
Just chiming in to say “thank you!” for this post, and also to high five you on your day job. It was my dream for a long time to find a way to go to college* and study economics and public policy so that I could contribute to these types of discussions. I’ve had to settle for reading the Economist, Paul Krugman’s writing, and an ever-growing stack of books – oh, and voting for Elizabeth Warren this fall! Anyway, it’s cool to bump into another economics nerd in the feminist community!
*And yes, I am aware it is never too late to go to college, it is simply not the right time for me right now.
how likely is it that this scandal will open the door for criminal prosecutions by the US or British government and finally put some bankers behind bars?
Wow, how cool to log into Feministe after a long time away and see it covering such an important topic!! When did this place become a feminist econ/banking regulations blog?
Question for Kristen — Wasn’t the LIBOR manipulation actually downward, meaning that consumers with contracts tied to Libor may have actually benefitted from lower interest rates?
For those astonished that banks can set rates like this — they’re not actually setting the rate that anyone is forced to use, per se. They’re setting a rate privately that many private parties use in their contracts when you have an adjustable rate — e.g., the rate would be 3% plus LIBOR. I remember back when I took out a whole huge chunk of adjustable rate law school loans, I could chose to have them indexed by LIBOR or US Treasury bills. I chose LIBOR because I had some notion that they were more stable than T-Bills. Don’t know why!
About consumer class actions — As a plaintiff’s lawyer I’m always optimistic about class actions! Even if the manipulating banks did not do business directly with the consumer, the banks sure as hell knew that millions of contracting parties relied on LIBOR’s integrity. There has to be a legal theory somewhere that will work. If any of the banks had a role in the origination or securitization of the loans, then that might work too.
@md,
The current allegations are that the LIBOR was adjusted both up and down. I think that was discussed in the Economist coverage, but I know its in one of the links above. I would argue that consumers got screwed on both sides of the transaction since if LIBOR was adjusted down then many savers, pensioners, and persons living on a fixed income earned less interest than they should have. Of course we still don’t have specifiics about the who what when and how much.
@cfc,
I don’t know. I think recently US officials have been somewhat successful at pursuing insider trading cases, but I’m not sure any of the current allegations demonstrate that crimes occurred in the U.S. I will say the DOJ is investigating, but so far all that has come out of that investigation are enormous fines. I too would like to see some criminal indictments but I’m skeptical that a jury would convict someone in these cases and further that a judge would uphold those convictions.
For the lawyers –
Who gets slammed in these lawsuits? Is it the traders who did it or the bank as a whole? If, for instance, the corruption was concentrated in a small segment of the bank, can the bank be held liable?
I don’t think we know for sure, but I suspect in the US both. The brokers for insider trading and the banks for failure to supervise/compliance failures. At least on the trading side. On the anti-trust side i’m not positive.
That’s interesting. I wonder which would be more effective as a deterrent.
So basically because the rate was jerked around like a yoyo by a gang of criminals an individual can’t tell if they lost money or saved money. How would you even tell what a real free market would have set the rate at? This sounds like a fun crime to sort out and one in which someone someplace will have me opt-in to receive my $25 class action settlement check. I think when I get it I will invite the lawyers to lunch to thank them, it will be at McDonalds, possibly Burger King, or if we really score and get $50 – Popeyes.
I knew nothing about this. Thanks so much for the education!
Darn. My comment got lost in the ether. Or modded. Can’t be sure which.
But I’m more than a little envious of the way Iceland was able to shake things out after their financial crisis and banking debacle.
The way this is presented seems a little off.
For example, the link to “The Point” includes a statement by Robert Shapiro, who is quoted here, as saying a major part of the problem is that LIBOR is actually NOT set by a market (he uses the phrase “not determined by supply and demand”). This is actually the basis of the fraud claim: when the market was analyzed it was determined that trading occurred at rates consistently below the published rate during the time period in question.
In other words, the problem is that the published LIBOR is actually not determined by the free market, so the conclusion that this relates to pro free-market policies is actually a non sequitur.
There reasons why consumers benefit when markets are regulated, but this isn’t one of them. If anything, the biggest losers here were probably other financial institutions: LIBOR is set by 18 banks, but the majority of LIBOR-based derivatives are traded between financial institutions (this is stated in the MSNBC link in the article.
There is also no mention of the fact that consumers likely gained significantly duringmuch of late 2007 and into 2008 when LIBOR was actually underreported. (see http://online.wsj.com/article/SB121200703762027135.html ) This doesn’t forgive collusion, but it seems wrong to report that consumers were fleeced without acknowledging that they also likely benefitted significantly for some period of time.
@Mike, That’s sort of the point. There is a mythos built up around all sorts of market pricing mechanisms. LIBOR was considered a market pricing mechanism even though we knew there were too few buyers and Sellers. (And don’t weep for the Banks – they priced their own derivative transactions based on LIBOR – but then they also shed interest rate risk with other counterparties – that’s why pension plans and mutual funds are also suing.) There are a shit ton of these pricing problems in our economy from CEO compensation to gas prices. As to your second point, lots of people are also harmed in an artificially low interest rate environment.
@Sulyp, We must have angered the internet gods. Its not in the mod queue or the spam filter.
It’s usually the bank as a whole, because individual traders — even ones who made a lot of money — don’t have the kind of cash that a class action suit is looking for. As to whether the bank can be liable, my guess would be yes because rates were submitted on behalf of the bank (making it responsible for their accuracy), because a lot of these individuals would be considered agents of the bank, and because the bank has a responsibility to supervise its employees — it can’t just bury its head in the sand and then disclaim responsibility when an employee acting in the course of their duties perpetrates a massive fraud.
This goes back to a debate between Ludwig von Mises and Walter Eucken about the definition of “free market.” Mises thought it was just absence of government intervention, but Eucken argued that it was a constitutional framework that the government had to have a role in setting up, so that the benefits of market competition could be derived. One of the main points of contention was on the issue of monopolies, oligopolies and collusion. Mises thought they were fine as long as the government’s hand wasn’t involved, whereas Eucken thought they should be broken up because they undermined market competition. Or at least that’s how I understood it.
@Tony,
Very true. And it academia the neoclassical approach won that argument despite its logical flaws for a long ass time. Recently there has been a resurgence in NIE…so maybe the tides have changed.
Havent rates been at historic lows? The ones who got ripped off were the players who played by the rules, or am I wrong?
@Steffie,
Rates are at historic lows now but these allegations stretch before the recent recession when rates were around 8%.
Well were the rates manipulated both ways on a regular basis, up and down, or are you telling me, that the rates were artificially inflated to cause people who were on mortgages that change with the LIBOR rate to default?
?? I didn’t say anything about default rates.
The current allegation is that over a period of years the rates were artificially inflated and over another period of years they were artificially deflated. In both instances people were harmed.
I get the part where inflating the LIBOR harms people, but how did it harm people by artificially deflating them? Wouldnt it all even out, assuming people made the same ammount of debt during that time period and were not forced to default when they were artificially inflated?
Wouldnt people who made little debt when the LIBOR was high and took advantage of the artificially deflated LIBOR even some out on top?
I am not saying this isnt all highly illegal and a scam, I am just trying to understand how it does not only hurt the people who played the markets, but also everyday folks.
@Steffie,
Artificially deflating LIBOR hurts people living on a fixed income or people who were saving for a large purchase. If for example you are a retired person, the money you earn on your savings *is* your income. When the banks artificially deflated LIBOR those persons were harmed. More broadly every person who was attempting to save for retirement (either in a savings account or through a private retirement account or because their employer has a pension program) was harmed for much the same reason.
Whether it would “even out” is sort of a weird question. For a person who purchased a home with a fixed rate mortgage during the inflated period, its doubtful that person was made whole by a lower interest rate during a following period. The same is true of large swaths of the population. Individuals were harmed and if they were made whole by subsequent deflations then it was just by happenstance.
I guess if you’re concern is over all market effects, then maybe it “evened out” but I’m more concerned with how individual people were harmed.
It will be interesting to see if indeed just those 16 banks conspired, or if they were acting on a directive from even further up.
The more I know the more I don’t know seems to fit quite nicely when the information age makes more information about the government and big players available than ever before. I am fairly certain next time some shadowy group blows up averages joes and janes people wont just take the word of their government for it, that the bad guys just happened to be the ones in a country the west wanted to go to war with for the past 10 years.