The international LIBOR scandal “is akin to finding out that Greenwich Mean Time is off,” says Vermont State Deputy Treasurer Steve Wisloski. “It’s a big deal. It’s a very big deal.”
Vermont state and municipal bonds are insulated from the full force of the LIBOR fiscal fiasco, and Vermont consumers who borrowed at LIBOR-related rates may have actually benefitted from the international banking collusion. Vermont lenders on the other hand, including banks and investors, may have been harmed to varying degrees depending on the size of their financial transactions. The Treasurer’s Office and Tom Kavet, State Economist and Principal Economic Advisor to the Vermont Legislature, are keeping a watchful eye on the storm as more information emerges.
What is LIBOR?
LIBOR, or the London Interbank Offered Rate, is the international benchmark rate at which banks can borrow money from other banks. Every day, about 20 leading banks around the world report to the British Bankers’ Association in London the rate at which they are lending money to other banks that day.
Thompson Reuters, an international financial and business consulting firm headquartered in New York and under contract to the British Bankers’ Association, then performs the LIBOR calculation by lopping off the highest and lowest 25 percent of the reported rates, averaging the remainder, and translating the result into dozens of different currencies.
Then regulators discovered that bankers were emailing and tweeting each other to decide where the LIBOR should be set for the day depending on what transactions were on their calendars.
“Banks were colluding to put the rate lower, because lower rates appear healthier,” Wisloski explains. “Think of it as your cholesterol rate or your blood pressure rate. A lower LIBOR means financial institutions look healthier. So this was like lying about your blood pressure rate.”
While the daily blood pressure readings of the British Bankers’ Association may sound about as distant and dull as one can imagine, its impact rushes through the veins of nearly every American home.
Trillions of dollars of lending accounts are tied to the LIBOR rate, including nearly every loan with rate variability such as the adjustable-rate mortgages offered by most Vermont banks. Student loans from Citizens’ Bank and municipal bonds issued by most major U.S. cities are tied to LIBOR rates.
“It’s far away, but it seeps into financial contracts all over the place,” Tom Kavet says.
While there are other benchmark banking rate indexes, such as the Prime Rate set by the Federal Reserve, LIBOR has become the international standard as banking has gone from community to planetary scale and London has become the new Main Street of the global banking village.
Despite LIBOR’s role as the Greenwich Mean Time of the bank rate universe, “It’s really pretty poorly set up for something so important,” Kavet says. He sees it as symptomatic of the ills of banking deregulation.
“Part of it is the problem of having banks so focused on investments. That comes out of deregulation, which started in the Reagan administration but then in the Clinton administration, Glass-Steagall was gone,” he says, referencing the statute which created stringent banking rules in 1932 to prevent epic financial events like the Great Depression from happening again. Once those reins were let off, “It led to a free-for-all. It’s been a pretty expensive experiment.”
Ironically, if the collusion to manipulate LIBOR kept the rate low, it might have put a damper on potential market panic through recent years of financial crisis.
“People who looked at it analytically were scratching their heads when it didn’t go higher during the financial crisis,” Kavet says. “Had it gone higher, it might indicate that things were in worse shape with the financial institutions. So the manipulation may have had a calming effect.”
That calming effect is ending as banks have begun to see hefty fines and receive even heftier boxes containing the first of what will likely be a tsunami of lawsuits. “There will be a bit of a feeding frenzy with the lawyers for a while,” Kavet says.
Effects on Vermonters
Another odd silver lining to the LIBOR scandal is that people who were borrowing—such as homeowners with LIBOR-tied ARM mortgages–may have benefitted.
“Let’s say you have an ARM mortgage with a LIBOR rate +2 percent. If the LIBOR is artificially lower, then you’ve actually saved some money,” Wisloski says. “If they aren’t manipulating the rate anymore, the mortgage rates may be a little higher. But to put it in perspective, we are in a time of record low interest rates. For you or I as consumers it would be negligible changes. But in terms of larger scale lenders, anyone who was supposed to be bringing in money based on this rate, it adds up.”
Tom Kavet assures Vermonters that mortgage interest rates “are not going to spike and if you’re a borrower who has benefitted from this, no one is going to come and try to collect back money from you.” If your mortgage documents say “LIBOR” on them, you need not panic.
If you are on the lending side, however – an investor who owns mortgage-backed securities or contract derivatives, or you are in the banking business– you might be getting a little less money coming in. For big banks and investment firms, that little bit less on each account can add up to something big, and lawsuits are already being filed against the allegedly colluding banks by investment giants like Charles Schwab who are seeking to protect their clients, including the many Vermonters invested in their accounts, from the loss caused by the manipulated LIBOR rate. “But for the average consumer – is the tiny difference worth the cost of a lawsuit and the expenses involved? Probably not,” Kavet says.
The financial press is widely reporting that 16 banks worldwide are being scrutinized by regulators in the United States and Europe regarding possible participation in the LIBOR rate-setting manipulation. Of these, Barclay’s has already paid out $448 million in fines and fired its CEO and COO. Swiss Bank UBS, which has financial service offices in Vermont, has reportedly paid $254 million under an agreement to ‘fess up and pay up quickly.
Vermonters are not likely to have direct dealings with the eight other foreign banks that have attracted regulator’s attention, but at least five of the banks on the list have ties to Vermont, at least in the form of branch offices or related businesses: Bank of America, Citigroup, HSBC, JP Morgan Chase, and the Royal Bank of Scotland (which owns Citizens Bank). The Royal Bank of Scotland, along with German banking giant Deutsche Bank, are likely to see the highest fines, possibly over $1 billion each, Morgan Stanley analysts have reported.
“Liability to banks is in the tens of billions of dollars,” Steve Wisloski says. How that ultimately plays out in term of impact on bank customers, services, products and rates remains to be seen.
“The full extent of the manipulation hasn’t been discovered yet,” Kavet says. “The effect would be fairly small for homeowners or mortgage holders, but these banks do very big trades. “
Vermont State Funds
Vermont state employees’ pension funds are in the hands of one of those big-trading banks: JP Morgan Chase, already bedeviled by a bad trades scandal and now being questioned by regulators about its role in the LIBOR debacle. Wisloski expresses strong confidence that even potentially heavy fines will not rock the venerable JP Morgan Chase boat. “They will be questioned about it but they will probably weather the storm,” he says. The state depository bank is TD North, owned by Toronto Dominion, which has not as of yet been implicated in the scandal.
Municipalities across the country have filed suits against implicated banks, seeking to recoup losses on municipal bonds tied to a flashy financial technique called ‘synthetic fixed rate debt’ which Wisloski describes as “selling variable rate bonds then putting an internet rate swap on top of it.” With these rates tied to manipulated LIBOR rates, the municipalities should have been receiving a tiny bit higher rate of return, but “on a hundred million dollar municipal bond, even a fraction of a percent is huge.”
The Vermont Treasurer’s Office happily reports that “Vermont is free and clear in terms of bond risk on this. State of Vermont and the Vermont Municipal Bond Bank bonds exclusively use plain vanilla long term fixed rate bonds that are not affected by the LIBOR rate.”
Wisloski says that this is the logical and responsible tradition of conservative fiscal management which the current Treasurer, Beth Pierce, has continued going back through the prior treasurers Jeb Spaulding, Jim Douglas and beyond.
The advantage of avoiding engaging in fancy variable rate lending schemes is that “Our liability is fixed. We know what interest rate we are paying today and we know what interest rate we are paying 20 years from now,” Wisloski says. With the state’s high bond rating allowing for extremely low-interest-rate borrowing, the risk of embarking on variable-rate schemes with variable risks of exposure to events like the LIBOR scandal is simply not worth it.
Still, the scale of LIBOR fallout is yet to be determined, and impacts may appear in unexpected places. “It is a big deal to us in finance,” Wisloski says, “and we’ll keep an eye on it.”