Global Libor Scandal Cost States and Localities Millions

A few months ago, Baltimore Mayor Stephanie Rawlings-Blake publicly savaged international bankers for taking money out of the pockets of city residents. The bankers, she told reporters, “are pretty much playing fast and loose with the people they are meant to protect.” She added, “We are not afraid of a fight.”

How did a mayor of a medium-sized city end up dueling with giant banks like Barclays, Bank of America, Citigroup, HSBC, JPMorgan Chase and UBS? Like many state and local governments, Baltimore invested its cash in complex financial instruments, including interest-rate swaps. Rawlings-Blake and other litigants in a federal lawsuit are charging that the banks set interest rates artificially low, which cut governments’ investment returns and led to bigger spending cuts. No politician likes to slash programs or raise taxes. Every politician hates to discover they had to do so more than might have been necessary.

Because many state and local governments borrow at floating rates, investment returns can be highly unpredictable. So to smooth out the highs and lows, financial managers trade the floating bonds for fixed-rate investments. Most of the rates for floating bonds and swaps are pegged to “Libor,” the London Interbank Offered Rate. Insiders know it as BBA Libor (for British Bankers’ Association Libor), the product of a daily survey among bankers about the rates banks can get in the London market at 11 a.m. every business day, across a range of maturities. They toss out the highest and lowest rates, and the average of what’s left determines the interest rates that just about everyone pays for just about everything. In fact, anyone can follow the results on Twitter, @BBALIBOR.

This is rather arcane stuff, but it worked well through gentlemen’s agreements for decades until July of this year. In both the United States and the United Kingdom, government regulators found that traders working for one of London’s most respected banks, Barclays, had been playing Libor games by misrepresenting the rates. Soon government regulators in Canada and Switzerland joined in the investigation, which spread to 16 banks, including Bank of America, Citigroup and JPMorgan Chase in the U.S. Fallout quickly ensued when Barclays’ high-flying chairman Marcus Agius was forced to resign.

The regulators probed whether the banks had colluded to keep interest rates artificially low, in part to make money on trades and in part to convey the impression that, even in the financial meltdown, they remained solid companies. (The riskier the company, the higher the rates it would have to pay. So lower rates both helped banks play the market better and signal a rosy corporate picture.)

That takes us back to Baltimore, and a quickly growing list of state and local governments filing legal action. Their claim: By artificially driving Libor down, the banks cheated them out of enormous investment returns at a time when their budgets were already badly damaged from the Great Recession and when every dollar of investment income was a dollar of services that didn’t have to be cut.

The Libor scandal has exploded across the global financial scene. It’s already cost the jobs of top bankers and has dragged many of the world’s leading banks into a very harsh spotlight, just as they were trying to make the case for the return of financial stability. Mad-as-hell government officials, who concluded they slashed spending more than was necessary, are seeking compensation and retribution. Moreover, many state and local investment officials holding bonds with variable rates converted them to interest-rate swaps to stabilize their returns, but now they can’t get out of them because in many cases the penalties are too high. So not only are their investment returns lower than they should be -- they’re stuck with them.

Perhaps most fundamentally, the foundations of much they had taken for granted have been shaken. It turns out that the key benchmark for most interest rates around the world was Libor, and that Libor wasn’t the actual rates bankers charged but estimates that could be gamed. As blogger Darwin Bond-Graham sharply put it, “Libor was always a club of powerful banks inventing the price of money,” and with Agius’ resignation, the workings of that club came under investigation and the threat of criminal rate-fixing charges. According to one government official, “It’s hard to imagine a bigger case than Libor.”

That all leads to two final questions. First, why didn’t the feds step in sooner to help protect state and local governments? The Treasury had detected the problem a few years earlier, and even managed to extract a $450 million settlement from Barclays. Some state and local officials have complained that federal regulators were not riding shotgun for them.

Second, how much of the problem came from state and local investment officials putting money into instruments whose risks they didn’t really understand? As Jeffrey Gibbs, director of special investigations for Pennsylvania’s auditor general, put it, swaps, derivatives and other complex financial instruments are typically understood only by the people who sell them. It’s another searing lesson of the risks of governing in a globalized world, with state and local leaders forced to navigate through seas they can’t control and sometimes can’t even see.