LIBOR For Mortals: An Easy Explainer

The Canary Wharf headquarters of Barclays Bank in London, England.

Call it the Barcapalypse (as some wags on Twitter did): In a 48-hour span between July 1 and July 3, Barclays bank lost most of its senior management team: the chairman, Marcus Agius, the CEO, Bob Diamond, and the chief operating officer, Jerry del Missier, resigned over a scandal in which the bank was accused of manipulating the LIBOR interest rate. Diamond is reported to have felt "hounded" by members of parliament who were going to drag him into a public enquiry and take up all his time, with no one left to run the bank.

That leaves England's most important bank with absolutely no one in the executive office. Things work differently in England, as you can see; you didn't see Jamie Dimon resigning to avoid facing Congress last month. 

Barclays - nicknamed BarCap by Wall Street insiders - is known to most Americans mainly as the bank that bought Lehman Brothers. And LIBOR isn't known to most Americans at all. Yet this scandal is shaping up to be a big one. And one British bank and one international interest rate may have had a strong effect on average consumers here in the U.S.  The handy explainer below should explain who to be mad at, and why.**

I feel like we only ever get to talk when some obscure financial product goes horribly wrong.

It does seem that way, doesn't it? Like with JPMorgan and the credit-default swaps, and when European bonds were going nuts around the time of the Greek election? Luckily, this is a strong basis for a relationship. If we catch up every time Wall Street screws something up, we'll keep talking regularly for years.

So, catch me up. I've been reading about a LIBOR scandal in the papers. LIBOR is....?

It's actually not so difficult. LIBOR stands for London Interbank Offered Rate.  Let's take that one word at a time.

The London Interbank Offered Rate is an interest rate, set in London, by about 18 major banks including Bank of America, Barclays, JPMorgan, Deutsche Bank, HSBC and all the rest of the usual suspects.

Banks survive by borrowing from each other every single day. So these banks go to the British Bankers Association every morning and submit an offer, every morning, of how much interest they would have to pay to borrow from each other. That's why we call it the interbank interest rate.

To make sure that no one games the system, the BBA asks Thomson Reuters to eliminate the highest and the lowest offers, and pick a number around the middle. The LIBOR number is set by 11 a.m. every day for 10 currencies at least; but right now, the one we're concerned with is the U.S. dollar.

Side question: How many loans are based on LIBOR?

About $10 trillion worth. And then trillions more in derivatives.

Okay, but what does LIBOR really tell us?

LIBOR is a way to measure the health of the banking system. Banks have to judge on a daily basis whether the other banks they do business with are good for the money.

If LIBOR is high, it means that banks don't trust each other too much. It's just like when your bank raises your mortgage or credit-card rate -- they don't really think you're good for the money, and so they want you pay higher interest. Banks work the same way with each other.

But if LIBOR is low, that can also look bad. It was all the way back in 2007 that many people suspected that banks were fibbing about LIBOR to look more credit-worthy than they were. The Wall Street Journal's Carrick Mollenkamp -- who is now writing for Reuters -- explained it well:

Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates.

So, does LIBOR affect me?

Do you have any loans? Then LIBOR does affect you. Here in the U.S., banks have used LIBOR to set the borrowing rate for student loans, adjustable-rate mortages, and car loans.

So how did Barclays mess that system up?

Barclays tried to push down LIBOR to make itself look like it had really good credit. All the banks report LIBOR voluntarily, and the British Bankers' Association doesn't really call them out on any fibbing day-to-day - though, as we mentioned, everyone had their suspicions.

London's chief financial regulator, the Financial Services Authority, or FSA, alleges in this complaint that Barclays tried to manipulate LIBOR between 2005 and 2009 to make itself look as if it were flush with cash and getting great borrowing rates.

There was pressure. Other banks were submitting really low rates to the BBA, which made it look like they were finding it easy to borrow.

But during the crisis, Barclays was submitting consistently higher interest rates - in effect, telling the truth about high interest rates it was being charged- which made it look like Barclays was having trouble finding people to lend it money at a reasonable rate. Bob Diamond - who signs his name RED - said as much to the Bank of England, which was worried about Barclays' high lending rates. Other banks, at the same time, were reporting much lower rates to the BBA. Barclays thought the other banks were massaging their lower interest rate submissions to make themselves look good; in fact, the bank says it spent "nearly £100m to ensure that no stone has been left unturned" to clear its name in an internal investigation.

So Barclays turned it around and started fudging its rates too. Remember, low LIBOR means that banks trust each other more. So Barclays wanted to buff its image to look trustworthy, according to the FSA:

Barclays was identified in the media as having higher LIBOR submissions than other contributing banks at the outset of the financial crisis. Barclays believed that other banks were making LIBOR submissions that were too low and did not reflect market conditions. The media questioned whether Barclays’ submissions indicated that it had a liquidity problem. Senior management at high levels within Barclays expressed concerns over this negative publicity.

Did what Barclays did affect the price of my mortgage, though?

It might have. Reasonable minds can disagree. I asked a few people this question. Greg McBride, an analyst with BankRate.com, doubted that the LIBOR-toying really hurt anybody, because of the way LIBOR works: the extreme highs and extreme lows aren't reflected in the ultimate price. A market strategist I talked with said that yes, the LIBOR-fixing had an effect on how much we could trust banks, but really, one or two banks couldn't distort the whole market.

I also asked Guy Cecala, the editor of Inside Mortgage Finance magazine, this same question. His answer was: yes, it might have affected us, because the problem with LIBOR among banks during the financial crisis froze the consumer market for borrowing. Let's do a little time-traveling. Remember in 2008, when everyone was freaking out, Bear Stearns went under, Lehman Brothers and Morgan Stanley and Goldman Sachs were getting attacked every day, and a lot of people worried whether banks could survive? 

Here's how Cecala put it in his conversation to me:

After 2008, interest rates were dropping pretty quickly and the concern at the time was that LIBOR wasn't moving, so that banks weren't passing on the benefit from government bailouts. They were borrowing at virtually nothing and signalling that they wouldn't lend to the world at anything like those low rates. it didn't smell right, what was going on.

And you remember that, right? How it was so hard to get or refinance a mortgage, and how credit-card companies backed away from many consumers? That was a ripple effect from banks refusing to lend.

Why are some U.S. mortgages connected to LIBOR at all?

It has to do with how banks make mortgages manageable.

Let's start with a visual: Picture your mortgage like a giant evergreen tree. Back in the old days, when you asked Main Street Bank for a mortgage, it held your entire mortgage on its books; it would throw that tree in the backyard. Soon, hundreds of thick, heavy mortgage trees would pile up in the tiny backyard of Main Street bank.  If you defaulted on your mortgage, your tree would start smoldering. Not only would Main Street bank lose a valuable tree, but the whole pile could catch fire.

So big Wall Street banks stepped in and told Main Street bank that it would be smarter to chop all of its mortgage trees into easily handled firewood. Then Main Street bank could keep some bundles of your mortgage-tree, and sell the rest to other who wanted firewood.

A lot of the people who wanted to buy those firewood-sized mortgage bundles were in Europe, and they were used to LIBOR, the same way they were used to Celsius and metric. So the U.S. banks started using LIBOR to set the interest rates on all adjustable mortgages to help them sell the firewood bundles of mortgage loans to investors in Europe.

So, the FSA believes Barclays convinced other banks to lower the rate just for Barclays? Aren't bankers Darwinian? Why would they help out a rival? What was the incentive?

Partly love, partly money, and partly love of money.

The FSA looked through a whole bunch of emails that these Barclays traders sent to their friends at other banks. The emails are really schmoopy and embarrassing and sickly sweet, with lots of "anything for you!!!!!!" and "thanks a million dude!" and "Dude. I owe you big time! Come over one day after work and I’m opening a bottle of Bollinger.”

So basically, the traders were helping each other. They asked each other for favors, so it seemed personal.

Traders cut these kinds of deals on prices all the time, by the way. That's what traders do. They work for major financial institutions, but they basically function like rug salesmen at a souk in Morocco. Traders ask each other, "hey, can you price this higher," or "you're killing me on this low price, my boss is going to fire me; look, that's my blood on the desk already."

The difference is that traders aren't allowed to use those negotiations with things like LIBOR, which is very official and not designed to be messed with.

So you're telling me that these bankers - sorry, traders - basically tried to rig a $10 trillion market for a bottle of champagne and some compliments? Are you kidding me right now?

I am not kidding you. Sometimes souls are sold cheap on Wall Street.

Did they possibly have other motivations?

Probably. Greed, for one thing. This really could have helped them make money. And there's always an implied quid pro quo: "you help me make money now, I'll help you later." A trader who gives a friend a few points on an interest rate now could call in that favor later.

The banks like to use this excuse: when you look at the 2007-2009 period, things were really dire for banks during the financial crisis. Two banks -- Bear Stearns and Lehman Brothers -- actually did go under ultimately because no one would lend to them. The Federal Reserve and European Central Bank dropped interest rates, but LIBOR stayed high. Banks were borrowing cheaply from the Fed and charging each other much higher rates. So Barclays could have wanted to report lower rates to look more trustworthy.

The appearance of trustworthiness, ironically, could have been an incentive to Barclays to allegedly game the system.

Do banks still use LIBOR?

Interestingly, U.S. banks pulled back on using it after the financial crisis -- because it felt rigged to them.

So at least tell me there was a decent punishment for this.

Barclays paid a $450 million to three regulators in the U.S. and the U.K., and its chairman, Marcus Agius, resigned, yes. Its CEO, Bob Diamond, just quit, and so did its chief operating officer, Jerry Del Missier. Diamond also said he would not take a 2012 bonus because of the scandal. All these men have taken a big hit for their careers, but more importantly, they've created a problem that the U.K.'s most important bank is now without anyone to run it. It's also hard to imagine who could take on such a job.

These sound like fictional names. Bob Diamond? And Marcus Agius is his real name? Is he a time-traveling Roman centurion?

Maybe you're watching too much sci-fi? Actually, Agius is very British - Cambridge, old-school gentleman capitalist - and part Maltese. His middle names are Ambrose and Paul, if it helps.

Like a Roman general, he fell on his sword. His resignation letter reads, in part, "last week’s events – evidencing as they do unacceptable standards of behaviour within the bank – have dealt a devastating blow to Barclays reputation. As Chairman, I am the ultimate guardian of the bank’s reputation. Accordingly, the buck stops with me and I must acknowledge responsibility by standing aside."

As for Diamond, he's actually American, and his rise to the top of the clubby English banking system was rare. Diamond is from Massachusetts, grew up Irish-Catholic, and went to Colby College in Maine and the University of Connecticut business school - hardly the typical path for the Savile Row-suited brolly-carrying English banker. He spent years at Morgan Stanley and Credit Suisse and then came to Barclays in 1996, when its investment bank was trying to make headway into the U.S. He helped Barclays buy Lehman Brothers and became CEO in January 2011. His resignation is a surprise, if not a shock, and leaves the U.K.'s biggest bank with absolutely no one to run it for the time being.

Very noble. And the "Ambrose" thing helps, a little, actually. But to be realistic, there's no way that Marcus "Gladiator" Agius is really to blame for this whole thing, right?

Right. This is way bigger than him. The U.S. Justice Department, FSA and CFTC have been looking at this issue for years. And it's really unlikely that only one bank was tempted to mess with the rates. So you're going to hear a lot more about this, probably, and it's going to involve a lot of other major banks, probably. Barclays is probably just the first of many. 

 **This post was updated July 3 to reflect changing news.

About the author

Heidi N. Moore is The Guardian's U.S. finance and economics editor. She was formerly the New York bureau chief and Wall Street correspondent for Marketplace.

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