Caught rigging the game

Petrino DiLeo explains what's at the heart of the growing scandal at Barclays bank.

Caught rigging the game (Eric Ruder)

THE BRITISH banking giant Barclays has agreed to pay more than $450 million to several U.S. and European agencies to resolve ongoing investigations into an incredible financial scam it tried to perpetrate--but the scandal may only be beginning.

The uproar is about Barclays' manipulation of benchmark interest rates at which banks lend money to each other. That may seem like an obscure issue, it's nearly impossible to overstate the potential significance for the financial system. As former Labor Secretary Robert Reich wrote, "This is insider trading on a gigantic scale. It makes the bankers winners and the rest of us--whose money they've used for to make their bets--losers and chumps."

Barclays' manipulation of Libor--that's short for the London Interbank Exchange Rate--has dramatic repercussions. That's because Libor is used as a benchmark in any number of financial situations. For example, when you get or pay interest where the rate floats--say, the (meager) return you get from a deposit account at a bank or the interest on mortgage loans or credit card debt--that rate is calculated according to Libor. Anyone who has a variable rate mortgage is probably familiar with the formula "Libor plus X percent"--that's what sets the interest rate.

Libor is also used to structure the complex financial instruments known as derivatives--the very things at the heart of the Wall Street meltdown in 2008.

To take one example, various government entities agreed to deals called "interest rate swaps." The idea was to lock in a preset rate of interest on debts--based on where Libor stood when the deal was made--in order to avoid a hit if rates went up in the future. But interest rates have been at rock bottom since 2008, so the governments and public agencies that made these swap deals have had to pay billions in excess repayments.

All told, Libor affects $800 trillion worth of financial contracts of various kinds, according to the Wall Street Journal--more than 10 times the annual economic output of the entire planet.

What did Barclays do? Basically, investigations have revealed that the bank took various steps to rig the Libor benchmark so that its gambles on derivatives, like the government interest rate swaps, paid off for Barclays, at the expense of anyone on the other side of the bets.

E-mails from Barclays traders have exposed the scheme, and a number of top officials have resigned. But Barclays is just the tip of the iceberg. Nearly 20 other banks have been mentioned in investigations in Europe and the United States as doing the same thing.

As one anonymous bank CEO told the Economist, "This is the banking industry's tobacco moment"--a reference to the 1998 turning point when lawsuits and settlements cost America's tobacco industry more than $200 billion. "It's that big," he said.

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BY MANIPULATING Libor, Barclays benefited two different ways.

Prior to the Great Recession of the last few years, Barclays attempted to influence the Libor number to increase profits or reduce losses on money that was tied up in derivatives. According to the Economist, "[E]ven relatively small moves in the final value of Libor could have resulted in daily profits or losses worth millions of dollars [on these investments]. In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was £20 million ($40 million at the time)."

Then, after the Wall Street meltdown of 2008 and the onset of the recession, the Libor numbers reported by banks became a closely watched proxy for the institutions' health. The higher the reported rate, the riskier the bank appeared to be--a high rate meant other banks would demand higher interest to lend money on a short-term basis. Barclays has admitted to reporting that it paid a lower interest rate than was truly available as a way of making itself look stronger in the market.

As details of Barclays' Libor manipulation emerged, Barclays Chairman Marcus Agius and Barclays CEO Robert Diamond resigned in quick succession. Barclays agreed to pay $200 million to the U.S. Commodity Futures Trading Commission, $160 million to the criminal division of the U.S. Department of Justice and $92.8 million to Britain's Financial Services Authority.

But the rot goes well beyond Barclays. More than a dozen other banks are also being investigated for similar manipulation, including Bank of America, Citigroup, Royal Bank of Scotland Group and UBS. More fines, lawsuits and resignations may be in the offing. And there's mounting evidence that government officials and central bankers were in on the scam, too. As the facts continue to come out, "Liborgate" may end up being the mother of all banking scandals.

The details of naked manipulation exposed so far are already shocking. E-mails, instant messages and other documents show that Barclays officials were willing to manipulate Libor rates for multiple purposes, including, according to a Thomson Reuters report, "senior Barclays officials concerned that the bank would look weak if it reported too high a borrowing rate; interest rate swap traders trying to improve Barclays' derivatives trading position; even former Barclays traders begging for favors."

It was shockingly easy for banks to lie about Libor, despite its importance. The rate is set by a panel of 18 banks that report daily estimates of what interest rate they think they would need to pay to borrow money for three months from other banks. The top four and bottom four estimates are discarded, and Libor is the average of the remaining 10.

However, the numbers aren't based on actual transactions--they're estimates. So there's no way to check their accuracy. Given the massive incentives banks have to manipulate the figure, it's probably more surprising that the system has gone on this long without lies and deception being exposed before.

In the financial world, interest rates are talked about in basis points--that is, 0.01 percent, or one hundredth of 1 percent. It's estimated that the Libor manipulation may have pushed the reported rate 30 to 40 basis points lower than where it should have been. That may not sound like much, but the difference between, say, 1.6 percent and 1.3 percent could have massive implications, given the large sums of money and transactions affected.

"Everyone in the industry knows if you knock down a few basis points here and there, billions of dollars shift between counterparties," Jeffrey Shinder, an antitrust attorney in New York City, told Bloomberg. "This is price-fixing," he said.

Even more ominously, a document released by Barclays suggests it was directed by the Bank of England to manipulate Libor and make itself look healthier. So rather than cracking down on the gaming of the system, the institutions and agencies supposedly overseeing the financial sector were allegedly encouraging the fraud.

As details come out about U.S. institutions, it wouldn't be surprising to find out that the Federal Reserve and Treasury Department may have been giving the same kind of encouragement to U.S. banks.

Rolling Stone journalist Matt Taibbi accurately summed up the stakes in this scandal:

This is unbelievable, shocking stuff. A sizable chunk of the world's adjustable-rate investment vehicles are pegged to Libor, and here we have evidence that banks were tweaking the rate downward to massage their own derivatives positions. The consequences for this boggle the mind. For instance, almost every city and town in America has investment holdings tied to Libor. If banks were artificially lowering the rates to beef up their trading profiles, that means communities all over the world were cheated out of ungodly amounts of money.

Taibbi's last point focuses on an important area that may have been affected by Libor manipulation: so-called interest rate swaps.

Most local governments in the U.S. borrow money on the basis of a floating interest rate. Consequently, the rates on these loans are tied to a baseline, such as the U.S. Federal Reserve benchmark interest rate. However, Libor is also frequently used to set floating rates.

In the 2000s, Wall Street banks came calling on municipalities with a seemingly sweet offer. At the time, the Federal Reserve's benchmark rate was close to 5 percent, and there were concerns that it could go even higher.

Instead, Wall Street offered interest rate swaps--under which municipalities and other governmental bodies could trade their floating-rate debt for fixed interest rate debts agreed to by the banks. Then, each month, the party with the higher interest rate has to pay the difference to the other.

As explained by the left-wing economics magazine Dollars and Sense:

By issuing debt in the most favorable terms and then swapping interest-rate payments, a local government could transform its relatively low but risky variable-rate debt payment into a higher fixed-rate obligation that is lower than it would have otherwise been had the government gone straight to the market to sell fixed-rate bonds.

To many government entities, this looked like a good deal. The interest on the money it borrowed would be lower than what they would have to pay by selling bonds. But there was a risk, too: For example, if the fixed rate were 5 percent and the floating rate dropped to 4.5 percent, the municipality was on the hook for the 0.5 percent difference between the two rates.

In the wake of the Great Recession, central banks the world over reduced interest rates to historic lows. The Federal Reserve Bank dropped its benchmark rate to 0.25 percent. And Libor, after spiking briefly after the Lehman Brothers bankruptcy in fall 2008, fell precipitously as well.

As a result, interest-rate swaps have been a disaster government entities and public agencies across the U.S.--they agreed to a fixed interest rate at or near 5 percent, but floating interest rates are now down near 0 percent. That chasm has served as another bailout for the banks, as financially strapped local governments pay millions in interest payments as a result of the swap deals. And fortunately for the banks, the swaps were structured with massive breakup fees--meaning municipalities can't even get out of these rotten deals without forking over even more cash.

An analysis by Bloomberg in late 2010 showed that municipalities had paid out more than $4 billion to Wall Street in two years to get out of bad swap deals. The Philadelphia School District, for example, paid $89.6 million in termination fees to big banks because of swaps--about six times the amount the district spent on books and supplies for Philadelphia's schoolchildren in 2009.

The problem is widespread. Interest rate swaps are today the single-largest type of derivative in existence, making up more than 80 percent of the value of such contracts signed by U.S. commercial banks. On a global level, the total value of interest rate swaps was most recently estimated at $441 trillion by the International Swaps and Derivatives Association.

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WHILE THERE are other factors that caused the interest rate swaps to be so destructive, any manipulation to artificially lower Libor only served to exacerbate the problem. So ordinary people are paying an incredible price for the various scams Wall Street pulled off--in the form of mass layoffs of public workers, crumbing public schools and other facilities, and slashed spending on social services.

For example, according to the Dollars and Sense article quoted earlier, Oakland, Calif., faced a $58 million budget deficit in 2011, forcing layoffs and cuts to many departments and services. At the same time, the city has been paying millions each year to Goldman Sachs under the terms of a swap that Oakland officials signed in 1997. As Dollars and Sense reported:

The city agreed to pay Goldman Sachs a fixed 5.6 percent rate in exchange for a payment equivalent to 65 percent of Libor until 2021 on a notional amount beginning at $170 million, and reducing over time as the principle on bond debt it mirrors is paid off...

[T]he difference between Oakland's constant 5.6 percent obligation and whatever Libor happened to be on any payment date was always in the bank's favor. When Libor dropped to less than 1 percent in 2008, Oakland, however, was stuck with a toxic swap contract requiring millions in payments to Goldman Sachs each year, with no meaningful hedging function against climbing variable rates.

Another stark example of huge losses due to swaps is in New York state and various local governments. Late last year, the group United NY issued a 20-page study detailing how interest rate swaps have ended up gouging the system.

The report estimates that New York state, New York City and other New York public entities are today paying over $236 million per year to the big banks on just a few of these swap deals. And since January 2000, New York's Metropolitan Transportation Authority has already paid out a net $658 million to banks. To fund these payments, the MTA has demanded concessions from its unionized workforce, cut services and bus and subway lines, and repeatedly raised fares.

The implications of this scandal are so vast that is difficult to fully grasp. No one knows what Libor rates really should have been. While it's clear that rates were manipulated and contracts skewed as a result, it may be impossible to decipher how much each party got cheated out of for a particular transaction.

In the coming months, expect more banks to come forward and admit to the rigging. There will be more fines, and some heads will roll. But at the end of the day, the Obama administration will do what it does best: try to limit the damage and protect the industry.

Given the precedents set by the Obama administration so far--take, for example, the settlement with U.S. banks over mortgage fraud--it's likely that the government will come up with some figure in the billions that all implicated banks will have to pay. In the case of the mortgage settlement, the banks were hit with a paltry $26 billion fine, and the settlement capped damages and barred further lawsuits.

The end result of Liborgate will likely be another slap on the wrists for banksters rather than anything that changes how the rotten system operates. Nor is there likely to be any real restitution to the people who suffered at the expense of Wall Street's continued malfeasance.

The damage that has been done--the cuts in services and jobs, and the continued budget cuts imposed to fund the payouts to banks--will not be undone without a fightback from working people.