Why LIBOR matters

This point has likely been made elsewhere, but it strikes me that the real costs to U.S. taxpayers of the manipulation of LIBOR remain opaque. This is understandable – it’s a strange acronym for an abstract interest rate that doesn’t seem to have any effect on day-to-day life.

If only that were the case.

In reality, LIBOR plays a major role in one of the worst offenses by Wall Street during the past decade.  In the years following the collapse of the tech bubble, Wall Street needed new sources of revenue, and hit on derivatives. Like Ridley Scott’s Alien, they were the perfect technology in many ways – they were fiendishly complex, which allowed them to be sold with all sorts of hidden fees, and even more crucially made the buyers completely reliant on the sellers for information. They were also customizable for any client big enough to purchase them, which made them even more viable as mechanisms for hidden fees and risks.

Local and state governments, facing chronic budget challenges and rising costs, were among the biggest buyers of these securities, and particularly of a kind of derivative known as swaps. While they seem complicated, they’re actually fairly straightforward once you get the core concept, which justifies a slight digression.

George and Henry

For the uninitiated, swaps are perhaps easiest to think of in contrast to a traditional security like a stock or a bond. When someone (we’ll call him George) buys a bond from someone else (we’ll call him Henry), for example, George pays Henry once to buy the bond. Then Henry pays George periodic coupon payments until the bond matures.

What makes swaps different is that the two parties to the transaction both make periodic payments for the life of the contract, which means that each party also receives payments from the other for the life of the contract. Another wrinkle – one party pays a pre-agreed fixed rate (like Henry in the bond example) and the other pays a floating rate, typically based on LIBOR. This is the source of the industry jargon that one either “pays fixed, receives floating,” or vice versa.

For the more visually inclined, an example:

In this case, George pays Henry a fixed rate and receives from Henry a floating rate, and Henry does the converse. Again, both parties are on the hook for payments over the life of the contract, unlike a normal bond. And crucially, each side of the transaction can only make money if there is a positive difference between what they pay and what they receive.

The other crucial difference between swaps and traditional securities is that they are completely customized to the two parties involved, which means the requirements for disclosure are left to be negotiated between the two sides of the agreement. Given the level of complexity, this can result in less sophisticated buyers entering into contracts that include a range of abuses such as hidden fees and onerous exit costs.

Given those characteristics, it’s not so surprising to see who ended up losing when small town officials attempted to negotiate with the likes of Goldman Sachs.

Ripping Off Bedford Falls

So why would municipalities enter into these agreements? A 2010 Wall St. Journal article explains that municipalities were concerned in the early years of the last decade about borrowing costs, which created a demand for financing solutions. At the same time, Wall Street’s latest derivatives boom was gathering steam. The two met in the form of a “solution” – municipalities would issue bonds with floating rates in order to benefit from falling interest rates (which would lower their borrowing costs). To protect against rising interest rates, the local governments would also enter into swap arrangements with banks that required them to pay a fixed rate to the bank while receiving a floating rate from the bank, like George in the example above.

To put it mildly, this has not gone well for the municipalities. The problem – LIBOR, the basis of the variable interest payments owed by banks, fell steadily in the following years, creating losses for the municipalities when these rates fell below the fixed amounts they owed the banks. The Journal article has a nice visual summary of one such deal, in which the ultra-low rate policy of Bernanke’s Fed has pushed the variable rate the city receives far below the 3.99% fixed rate it has to pay its bank:

Source: Wall Street Journal

As for the scope of the problem:

The Service Employees International Union said Chicago, Denver, Kansas City, Mo., Philadelphia, Massachusetts, New Jersey, New York and Oregon all are in the hole on swaps agreements they made with financial firms. The required payments range from a few million dollars to more than $100 million a year, the union said.

This is where the hidden fees come into play. Not surprisingly, the swap deals appear to have been structured so that Wall Street made money in every possible setting, including in the case that the borrower needed to get out of the contract early due to unbearable costs:

The Los Angeles city council approved a measure this month instructing city officials to try to renegotiate an interest-rate deal with Bank of New York Mellon Corp. and Belgian-French bank Dexia SA. The pact, reached in 2006 to help fund the city’s wastewater system, currently is costing the city about $20 million a year. The banks declined to say how they would respond to a request to renegotiate.

In Pennsylvania, 107 school districts entered into interest-rate swap agreements from October 2003 to last June. At least three have terminated them. Under one deal, the Bethlehem, Pa., school district had to pay $12.3 million to terminate a swap with J.P Morgan Chase & Co., according to state auditor general Jack Wagner. J.P. Morgan declined to comment…

And all of this is, of course, playing out against a backdrop of plunging tax revenues and soaring costs for deliberately under-funded pensions and health care costs. It is not an exaggeration to say that in many places, payments to Wall Street are resulting in the layoffs of teachers and the gutting of public services.

The trouble with LIBOR

The final way banks may have made money on these deals – if it is true that LIBOR was manipulated downward, then municipalities have been underpaid, potentially significantly. It would be hard to quantify, but considering that Moody’s estimates that the total market for municipal derivatives peaked at $500 billion, even a small amount could be meaningful.

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