What Does the LIBOR Scandal Mean For You?
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The LIBOR, or London Inter Bank Offered Rate, is a measurement of the interest rate that major banks are paying, or would pay, to borrow money from other banks for the very shortest of time frames, from overnight to one year. It is calculated as an average of rates submitted daily to the British Bankers Association, and is generally used to assess the confidence of bankers in the overall financial system. A low interest rate indicates a high degree of confidence.
The major flaw with the LIBOR is that the numbers are self-reported, with no evidence offered or required. Every day, the BBA surveys 18 major global banks with the question, “At what rates could you borrow funds, were you to do so by asking for and then accepting their inter-bank offers, in a reasonable market size just prior to11:00 AM?” The four highest and lowest responses are discarded and the remaining ten are averaged.
The LIBOR is significant as a basis for thousands of mortgages, student loans, credit card and auto loans, as well as for more complicated financial products. Any discrepancy in the rate can affect more than $300 trillion dollars’ worth of financial derivatives worldwide.
If a bank deliberately understated the rates at which it could borrow, as has happened in this case, in effect it was overstating its own confidence in itself and in the world’s financial system. The low LIBOR rates that have prevailed during the past few years have underestimated the instability and uncertainty. They have misled the world about the financial positions of the banks in particular, and in the world economic situation in general.
And even more alarming, the second reason for the banks to deliberately understate the LIBOR was to benefit their own trading positions. Because the LIBOR is tied to such a vast amount of financial products, a difference of even one or two basis points could add up to significant gains.
Various governments are investigating banks in their jurisdictions, including Barclay’s (NYSE: BCS) in London, RBS in Scotland, and several big institutions in the United States: Bank of America (NYSE: BAC), JPMorgan Chase (NYSE: JPM), and Citibank (NYSE: C).
Barclay’s was the biggest loser and admitted to the rate manipulations in June, with the resignations of their CEO Bob Diamond, the Chairman Marcus Agius, and the COO Jerry del Missier, as well as being fined $450 million by regulators in the U.S. and the U.K.
No charges have been leveled against the bigU.S.banks yet, but the OCC Bank for International Settlements estimated in July that their potential liabilities were minimal. JPM was estimated to have $4.8 billion in exposure, or $1.25 per share, for a 3.5% discount in tangible book value. The estimate for Citibank was $3.1 billion, $1.01 per share, and a 2.0% discount in tangible book value, and the numbers for Bank of America were $4.2 billion, $0.39 per share, and 3.0% in tangible book value
What does this mean for the individual consumer? You may have actually benefited over the past few years, if you have a mortgage or other loan tied to the artificially-low LIBOR. Your interest rate may have been a few percentage points lower than it would have otherwise been. On the other hand, if you participated in any investments that were tied to LIBOR, such as pension funds or mutual funds, you may have lost out in the lower interest-rate climate that prevailed during these years.
In terms of the bigger picture, though, this just shows that major financial institutions still cannot be trusted to do what is right for consumers. When given the opportunity, they colluded, they lied, and they manipulated for their own benefit. Andrew Lo, professor of finance at MIT, said, “This dwarfs by orders of magnitude any financial scams in the history of the markets.” Once again, the big banks have proven that they have only their own interests at heart.
khern0203 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America, Citigroup Inc , and JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.