What Is Libor and Why Should I Care?

Last week, a fifth financial institution acceded to allegations of rigging the Libor rate, reminding us that major financial scandals ain't over till they're over. Rabobank's $1.1 billion dollar settlement can serve as an opportunity to take stock again of what the Libor manipulation represents and where it stands.

What is Libor?
Libor, the London Interbank Offered Rate, is a financial index or benchmark. For many years, it has been synonymous with "the cost of money." Although its name refers to London, Libor is terrifically important at all levels of the U.S. financial system. Consumers will find it written into credit card agreements, student loan contracts, and adjustable rate mortgages, particularly at the sub-prime grade. At the higher levels of the financial system, corporations and municipalities use Libor-linked financial derivatives to protect themselves against volatile interest rates. If Libor goes up, borrowers of all stripes pay more. Libor is calculated by polling representatives at some of the world's largest banks, such as the Dutch lender Rabobank, about how much they would have to pay to raise money today. For a variety of reasons, this polling process was conducted on the honor system rather than with quality checks and oversight. Four banks and one intermediary have now admitted that their employees were sometimes untruthful in ways that were supposed to help them or their employers.

Did Rabobank harm me in some way?
It looks like traders and rate submitters at financial institutions like Rabobank made money by placing bets on Libor and then moving the rate in such a way as to win their bets. Like all manipulation, this behavior hurts the credibility of the market and increases volatility. But it does not, say, result in you paying an inflated mortgage rate, since they were as likely to push the rate down as to raise it. Indeed, a second kind of manipulation concerns a persistent downward biasing of the rate, which would have lowered borrowers' payments. During the financial crisis, banks may have wished to submit Libor rates that minimized the difficulty they were having in obtaining funds. Lower rates imply that the market trusts you, higher rates scream "I'm the next Lehman or Bear Sterns." That kind of manipulation, which could arguably have been good for borrowers, was not the focus of the Rabobank settlement.

A billion-dollar settlement. I forget: is that a lot or a little?
Everything is relative. At a time that JP Morgan negotiates a $13 billion settlement relating to mortgage-backed securities, a billion-dollar deal seems like just the minimum ante at what has become a high stakes table. On the other hand, it is more than twice what Barclays paid last year and it came with admissions of serious wrongdoing. It is the kind of money that could keep the lights on at the CFTC.

Where do things go from here?
There will be more investigations and settlements. There are still many banks that have not entered into any sort of settlement with regulators - more than a dozen just for the USD Libor rate, and there are many rates. And for those institutions that have settled, the agreements do not purport to close the book on Libor. Settlements with the CFTC and Department of Justice preserve the opportunity for investigation of manipulation of other rates, or under different legal theories (such as price fixing laws).

And then there are the civil plaintiffs. Pension funds, municipalities, the funds associated with Charles Schwab, and others have filed lawsuits seeking redress for harms they may have suffered from manipulation. These plaintiffs have tended to pursue the other theory of manipulation, arguing that they were paid less than they should have been as Libor trended downward. Those actions suffered a setback in March when a federal judge ruled that the banks' alleged behavior would not have violated antitrust laws, but that ruling is up for appeal soon and there are other claims besides antitrust.

And then there are the traders and rate-submitters, such as Tom Hayes, who is said to have been a very productive Libor manipulator during his career at several banks. His fate will depend in part on whether he is charged in such a way that will practically preclude prosecution in the United States, too. Relatively few individuals have been criminally punished as a result of misdeeds during the financial crisis. For Hayes and a few others, Libor could be a noteworthy exception.