Libor Scandal: The Biggest, Least Understood Rip-Off of All Time

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Today, some of the biggest banks in the world are expected to plead guilty to criminal charges relating to the Libor scandal. That makes this a good time to review what happened, how it affected you and whether the punishments fit the crime.

A little history

Back in 2012, a scandal unfolded that made the crimes of Wall Street’s Bernie Madoff look like kid’s stuff. And yet, despite the trillions of dollars involved and the sheer audacity of the fraud, the mainstream media didn’t give it much attention.

Today’s announcement of charges against some of the banks involved is bringing the scandal back to life. But if past is prologue, it again will not warrant the attention it deserves.

Anatomy of a rip-off

You probably don’t think much about where interest rates come from. On everything from credit cards to savings accounts, you’re presented with a rate, then you simply decide whether or not to take it.

Whether you’re borrowing or investing, you logically assume the rates you pay or earn are set by competition.

But interest rates on trillions of dollars worth of financial products start with a benchmark called the London Interbank Offered Rate, or Libor. While the label makes it sound complicated, it’s just the average interest rate big banks pay to borrow from each other.

It’s called “London” because it’s computed in that city. But it affects interest rates worldwide on some (but not all) adjustable-rate mortgages and credit cards, as well as student, car and other types of loans.

Libor isn’t set by supply and demand or the government. Instead, it depends on the banks involved to accurately report the interest rates they would have to pay to borrow from each other. The highest and lowest rates are thrown out, the rest are averaged, and Libor is set.

Libor depends on honesty. If banks don’t tell the truth, Libor won’t be accurate — nor will the interest rates on the loans and investments tied to it.

According to CNN Money, the amounts involved are staggering: $10 trillion in loans, as well as $350 trillion in securities, are tied to Libor.

To put that in perspective, Madoff’s infamous Ponzi scheme — considered one of the biggest in history — involved about $60 billion. That’s less than 1 percent of $1 trillion. In fact, the combined value of everything the United States produces every year, known as GDP, is only about $17 trillion.

Why did they lie?

Banks have two reasons to lie about the rates they pay to borrow.

The first is to make themselves seem stronger than they are. As with you and me, if a bank is a good risk, it will pay less interest when it borrows. So if a bank reports that the rate it pays to borrow from other banks is low, the financial world will think it is strong.

A bank also can make money by lying about what it costs it to borrow. Major international banks do more than lend. They also trade stocks, bonds and all kinds of other investments for the same reason any investor does: to make a profit.

Traders working for banks participating in Libor could simply buy an investment that goes up when rates fall, then lie about their rates in an attempt to lower Libor. In short, they could manipulate the market and position their investments to make money, essentially trading on inside information. This is especially true if banks magnify the impact of their reporting by colluding with one another.

How did it affect me?

Since Libor is the benchmark for many other rates, an inaccurate Libor means millions of people around the globe might have paid more or less interest than they should have on any number of loans.

If rates were artificially low, borrowers for things like adjustable-rate mortgages and student loans would have benefited. But investors in those loans — such as cities, mutual funds and pension plans — may have earned less than they should have.

The extent and impact of Libor manipulations will likely never be entirely known. The effect on the average consumer is probably small, but it could be measurable to people with large loans tied to Libor, like those with adjustable-rate mortgages.

What just happened?

The Justice Department is expected to announce today that Barclays, JPMorgan Chase, Citigroup and the Royal Bank of Scotland will plead guilty to criminal charges and agree to pay what will collectively amount to billions in fines. UBS is expected to announce a penalty, but will not be charged criminally.

While this may sound harsh, keep in mind these banks earn billions annually. None will remotely approach going out of business, or even be seriously financially injured.

What about the criminal pleadings? While pleading guilty to a serious crime would irreparably damage your ability to find work, the effect on these convicted criminals likely will be minimal. Because of their status and power, these banks have the ability to do something you can’t: petition for waivers from the SEC so they can do business as usual, despite their convictions. To read more about that, check out this article from the New York Times.

What should I do?

First and foremost, be mad.

Be mad that you’re expected to play by the rules in a system where the biggest players don’t. Be mad at regulators that didn’t properly regulate. Be mad that making billions in legitimate profits isn’t enough for some financial institutions: They have to game the system to make even more. Be mad that even when they do get caught, they don’t suffer to nearly the extent you would if you played fast and loose with the law.

And laugh out loud the next time you hear some congressman, lobbyist or CEO whine that banks are overregulated.

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