Two summers ago, the head of Britain’s Financial Conduct Authority, Andrew Bailey, made news when he announced that LIBOR – the leading benchmark for setting global interest rates – had a “sustainability” issue. The rate is supposed to measure the rate at which banks borrow from each other, but Bailey said it wasn’t based on real borrowing.
“The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks,” he said. “If an active market does not exist, how can even the best run benchmark measure it?”
These comments by a senior British regulator were draped in enough jargon that they barely reached non-financial audiences. Still, it was jarring.
LIBOR, the London Interbank Offered Rate, helps set rates for hundreds of trillions of dollars worth of financial instruments, including swaps, annuities, credit cards, mortgages and other products. If Bailey was right, it meant a sizable portion of global economic activity rested on magical thinking.
A secondary concern involved manipulation. If banks were inventing numbers to submit to the LIBOR committee, could they not also be manipulating rates to line pockets? Bailey didn’t delve in that direction, but the possibility certainly seemed to exist that the world’s major investors – including localities and pension funds – were being systematically ripped off.
At the time, I joked Bailey’s comments might inspire a pan-civilization lawsuit called Earth v. Banks. It hasn’t come to that did, but a class of investors and retirement funds including Putnam Bank and the Hawaii Sheet Metal Workers Pension Fund did recently bring an antitrust suit alleging just such a scheme. The July 1 complaint is an amended version of a class action suit originally filed earlier this year.
The action against JP Morgan Chase, Bank of America, Citigroup, Barclays, and numerous other banks uses both documentary evidence and data to argue that banks have been purposefully depressing interest rates. The idea would be to lower payouts to investors who are contractually due to receive LIBOR, while lessening costs for LIBOR borrowers, many of whom are banks.
LIBOR was once set by the British Bankers’ Association. It’s now managed by the Intercontinental Exchange, owners of the New York Stock Exchange, which rebranded it “ICE LIBOR.” Since February, 2014, ICE LIBOR has been “the world’s most widely used benchmark for short-term bank borrowing rates.”
Every day, by 11:40 a.m., a panel of 18 of the world’s biggest banks tells ICE how much they estimate they’d have to pay to borrow from other banks, by answering the following question:
“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”
LIBOR was originally created during a time when banks were borrowing a lot of cash from each other. Beginning in the nineties and early 2000s, however, banks began to use other venues, like the Treasury Repo market, to obtain financing when needed. Interbank lending tapered off.
Because of this, for years and years, when banks on the LIBOR panel submitted numbers, they were apparently just submitting guesses based on what they believed it would cost to borrow, if they actually were borrowing.
Jerome Powell of the Fed’s Board of Governors and Christopher Giancarlo of the Commodity Futures Trading Association wrote an editorial in the Wall Street Journal in August, 2017, putting it this way:
“… banks no longer borrow much in those markets. In essence, banks are contributing a daily judgment about something they no longer do.”
The authors added a lack of real data means, “submissions by panel banks are largely based upon judgment (as opposed to transactions).” A Fed official later wrote that some LIBOR submissions were based on “no transactions at all.”
In other words, banks were guesstimating. Why? After the crash, regulators sniffed out two motives for manipulation.
The first cases involved suppressing LIBOR in 2008 and 2009, to create an artificial impression of market stability during the crisis. In one incident, the Bank of England was accused of asking Barclays chiefs to “just do it” and push LIBOR lower, so as to reassure the public.
In a second, more grotesque form of corruption, individual traders at various banks goaded LIBOR submitters to move rates to protect certain investments. In an infamous case involving the Royal Bank of Scotland, traders were nabbed in texts offering LIBOR submitters everything from sex to “sushi rolls from yesterday” to drop LIBOR “like a whore’s drawers.”
Even though these two problems were ostensibly corrected, LIBOR was apparently still being contrived. As evidence, the suit points to published statements from the banks themselves, including members of the The Alternative Reference Rates Committee.
The AARC is a group of “market participants” that includes Bank of America, Citigroup, Barclays, Rabobank, Deutsche Bank, BNP Paribas, and UBS, among other banking institutions. Formed by the Fed after the 2008 crash, the AARC was designed to “help ensure a successful transition from US dollar (USD) LIBOR to a more robust reference rate.”
In other words, in a typical post-crash absurdity, many of the banks asked to help reform LIBOR were the same companies that earned giant regulatory settlements for abuse of LIBOR. As plaintiffs put it:
“Many of the same banks that provided the reason for reforming and replacing BBA LIBOR in the first place… were in a position of control over reforming and replacing the benchmark.”
This ]committee of market “participants” in September of 2018 published the following:
“LIBOR is increasingly based on the expert judgment of panel banks due to the declining amount of unsecured, wholesale borrowings by banks… the scarcity of underlying transactions also makes LIBOR potentially unsustainable…”
The AARC quote suggests the banks themselves were cognizant, both in-house and in consultation with each other, that LIBOR for some time has been based on “judgment” instead of “transactions.”
The complaint includes charts comparing LIBOR rates to various other market indicators dating back to 2014, including credit default swaps, treasury repurchase general collateral (“GC”) rates, and the yields on the banks’ own bonds. They found the rates were not only consistently mismatched, but mismatched in the same direction – LIBOR was lower in each chart.
How would banks make money by moving LIBOR down across the board? The suit argues the answer lay in the individual banks’ treasury departments, which are responsible for funding other operations within the bank. Plaintiffs argue that the banks’ funding desks have been using interest rate swaps to convert long-term fixed rate borrowings to holdings indexed to LIBOR.
“For example, in 2016,” the suit reads, “Bank of America reported that by swapping fixed-rate liabilities for USD ICE LIBOR liabilities, the firm was able to earn more than $2 billion dollars over and above what it would otherwise have earned.”
This is not easy to follow, but the gist is banks have been taking large sums borrowed on fixed rates and using swaps to make their interest payments more based on LIBOR. Because they have some control over LIBOR, which has been kept artificially low, they end up paying less. Conversely, any investor who is receiving LIBOR in return – this can include anything from pension funds to bond funds to other banks – will get paid less.
“Defendants conspired to depress USD ICE LIBOR rates during the Class Period,” the suit reads, “with the purpose and effect of depressing payments by Panel Bank Defendants on USD ICE LIBOR Financial Instruments…”
The public has already had time to grow tired of hearing several absurd iterations of the LIBOR scandal. We’ve heard it was rigged to make markets seem safer, then that it was rigged to make a bunch of twenty-something trading sociopaths bigger bonuses.
Two years ago, we learned LIBOR was probably not based on reality, an assertion that by now is not even really controversial (witness Bloomberg describing LIBOR last month as “just a made up number, or an aggregate of made-up numbers”).
The new concept: LIBOR is not just made up, but has been kept systematically low to tilt the entire lending landscape in favor of megabanks. It’s hard to conceive of a settlement broad enough to compensate for years of that kind of activity.
LIBOR is set to be phased out in 2021. If you read the financial press closely, you’ll note occasional semi-panicked comments to the effect that no one has a good plan for replacing the rate written into trillions of dollars of contracts.
Here and there you’ll find the 2021 compared to Y2K, an unavoidable changeover whose consequences are unknown. “Now, like then, words like apocalypse and panic are being spoken and written,” wrote Forbes last October.
There’s some sentiment for changing out LIBOR for the Secured Overnight Financing Rate (SOFR), which measures the cost of borrowing cash collateralized by Treasury Securities. SOFR, however, measures secured borrowing, while LIBOR is supposed to measure unsecured borrowing, a significant difference. People who made investments expecting to receive LIBOR may not be happy with getting SOFR instead. It could be a mess, all over the world.
As Forbes put it, sorting all of this out before 2021 is “a full employment act for Wall Street analysts and lawyers.”
The new lawsuit is probably just the beginning of many serious legal battles. If LIBOR’s past is any guide, it will throw us a few more curveballs before the end.