Mike Maciag is Data Editor for GOVERNING.E-mail: firstname.lastname@example.org
When news broke that the British bank Barclays had rigged the London interbank offered rate, or Libor, it came as no surprise to many in the municipal finance world. Some, like the city of Baltimore, had already taken action in the form of a lawsuit.
Use of interest-rate swap agreements tied to Libor soared beginning in the 1990s as governments sought to hedge against rate hikes and add certainty to budgets, with banks receiving fees. When interest rates plummeted once the recession hit, public agencies were faced with two unattractive options: lose money by failing to refinance floating rate debt or pay hefty contract cancellation fees.
To make matters worse, recent allegations of banks manipulating the Libor rate revealed further losses agencies may have suffered.
“It was a bad deal to begin with, and now we also find out that the situation was rigged,” said Sharon Ward, executive director of the Pennsylvania Budget and Policy Center.
Some state and local governments began scrutinizing interest-rate swap agreements long before Barclays reached the settlement with U.S. and British authorities in late June. Financial institutions across the U.S. have since filed dozens of lawsuits against banks responsible for setting the benchmark rate. Municipalities could soon follow their lead, with attorneys general in New York, Connecticut, Maryland, Massachusetts and Florida investigating the allegations.
It's difficult for governments to put a dollar figure on any losses with the complexities of how Libor affected varying contracts dating back years. Municipal finance experts and public officials contacted for this story say governments are now generally waiting for guidance from litigation firms and state attorneys general to recoup any losses.
Major banks submit rates at which they borrow from each other to the British Bankers Association, which then calculates an average after discarding the highest and lowest four submissions. This figure, or Libor, serves as a benchmark to set interest rates for mortgages and an array of other financial products, including interest-rate swaps. Even the slightest manipulation of the rate could shift an estimated $800 trillion in credit-related investments.
How interest-rate swaps are structured varies widely. In many cases, counterparties paid governments a variable rate of interest based off of Libor. If the rate was artificially inflated, states and localities lost money.
That’s what happened to the city of Baltimore and the New Britain Firefighters’ and Police Benefit Fund, according to a class action lawsuit alleging banks conspired to manipulate Libor.
The law firm Hausfeld LLP contacted the city long before the Barclays settlement was made public. Michael Hausfeld, the lead attorney representing Baltimore, told Governing his office has since received dozens of inquiries from municipalities across the country about the case.
“Libor is one of the most ubiquitous indices in the financial world, so this was pervasive,” he said.
One analysis by Keefe, Bruyette and Woods, Inc. examined how much banks involved in the alleged scheme could owe firms and others affected, pegging the total payout at $35 billion.
Hausfeld said his office is in the process of outlining guidelines determining which municipal entities lost out because of Libor rate changes.
“We’ve got to get the details of what happened, who did what, when, and what the price movements were,” he said.
In its settlement, Barclays admitted manipulating Libor up through 2009. But to have any considerable effect on the calculated rate, other banks would’ve needed to be in on the fix. The Economist noted earlier this month that as many as 20 financial institutions have been named in different probes or lawsuits.
By keeping rates artificially low, the banks would appear financially healthier than they actually were.
In Baltimore, seven interest-rate swaps funding parking garages were tied to Libor. City Finance Director Harry Black, who assumed his role in January, said officials first considered legal action when Hausfeld’s law firm contacted the city more than a year ago. Although the suit has been filed, the firm has not yet determined how much the city may have lost.
“From my vantage point, we don’t think that the number is going to be a big number,” Black said. “But we’ll take all that we can get, particularly during these tough economic times.”
It’s equally important, Black said, that banks involved in the scandal are held responsible for any wrongdoing.
“The idea is that there would be some remuneration back to the city and these institutions will be held accountable, and hopefully serve as a deterrent for any future activity like this,” he said.
The Municipal Securities Rulemaking Board, the industry's self-regulator, announced Monday it would study processes to develop municipal market indices. Alan Polsky, MSRB's chairman, told reporters he did not think there was a "smoking gun," but, rather, the effort was aimed at boosting education and transparency within the marketplace.
Use of interest-rate swap agreements accelerated in the late 1990s and early 2000s as investment banks pitched the products to governments. The deals often made sense at the time. But some officials, particularly with smaller agencies, probably didn’t know what they were getting into, said Justin Marlowe, a professor at the University of Washington.
“When properly used, these swaps can be a really effective tool,” he said. “But like any tool, they can be misused.”
For municipalities with contracts that didn’t pan out, revisiting the deals might be unappealing. “They don’t want to dredge up all these past practices they’ve been trying to distance themselves from,” Marlowe said.
But for governments with a lot of money tied up in derivatives linked to Libor, legal action is more attractive, particularly if the effect of the rate changes were all in the same direction.
Calculating any net loss resulting from rate fluctuations is challenging, requiring municipalities to assess their entire portfolio, Marlowe said. Municipalities often hold different types of derivatives spanning many years, all influenced by Libor differently. For each investment, one would need to account for all manipulations of Libor, whether up or down.
Marlowe estimated one or two of every ten municipalities may have actually come out ahead in swap contracts.
Interest-rate swaps are most common among entities with more unpredictable revenues, such as hospitals, utilities and ports, Marlowe said. School districts and local governments, especially along the coasts, also pursued the deals.
In Pennsylvania, 86 local governments and 107 school districts entered into swap agreements between October 2003 and June 2009, according to a report by state Auditor General Jack Wagner.
Many of these deals ended up costing taxpayers severely. A study by the Pennsylvania Budget and Policy Center examined finances of the city of Philadelphia and School District of Philadelphia, finding a total loss of $331 million stemming from the agreements.
“Had the Libor rate not been artificially inflated, there clearly would’ve been less of a loss,” said Sharon Ward, who authored the report.
Agencies exiting their contracts early typically paid substantial cancellation fees. The city of Philadelphia paid termination costs ranging from $15.2 million to $48.8 million per swap, according to the report. Ward said officials should be more aggressive in attempting to get this money back.
Marlowe said he expects some rules of thumb for agencies to soon emerge. Law firms looking to sign up municipalities in lawsuits will reach out to those holding certain products from select banks. More state attorneys general will likely get involved as well.
"There’s a lot of political hay to be made here,” Marlowe said. "No one is particularly fond of banks now."