There hasn't been a lot of news in the financial sector lately that puts investors' minds at ease. Adding insult to Great-Recession injury, the past few months have been full of new allegations, investigations, and fines for the world's banks' involvement in rate-rigging. And while the current LIBOR scandal seems to be mainly focused on European banks, U.S. investors should be careful not to get too comfortable -- this is just the beginning.
LIBOR 101
Founded in the 1980s, LIBOR is the London Interbank Offered Rate, which is calculated daily based on rates provided by a panel of banks. The rates quoted are estimates of the interest a bank would be charged to borrow from one of the other banks on that day. The quotes are compiled and averaged to determine that day's LIBOR rate, which affects over $500 trillion in financial instruments, including home mortgages, credit card interest rates, student loans, and more complicated investments like derivatives.
Until the scandal surfaced, the reporting process was not regulated by a governmental agency -- it was left up to the banks to monitor the process. This is where things went awry. Brokers and traders figured out that by colluding with one another, they could manipulate the calculated rate and profit from investments that LIBOR affected.
UBS (UBS 1.29%) has turned out to be the bank ringleader in the scandal, using rate-rigging to not only profit from investments, but also to appear strong during the financial crisis . Interest rates are usually determined by a lender's confidence in the borrower's ability to pay back the loan. By reporting low rates, UBS was saying that other banks had confidence in its ability to pay off loans -- projecting (false) financial strength. The Swiss bank was recently ordered to pay $1.5 billion in fines for its involvement in the rigging scheme.
Bad for all involved
So far, 16 banks have been implicated in the rate manipulation schemes. While most of them are European banks, both Citigroup (C 1.64%) and JPMorgan Chase (JPM 0.91%) have been directly connected with UBS ' actions. Additionally, Bank of America (BAC 1.06%) was subpoenaed by U.S. state prosecutors in October, though it's still not clear what the banks involvement was in the scandal.
While it's important for investors to understand which financial players were involved in the rigging, it's equally important to figure out who the true victims of the scam are.
Consumers: Manipulated rates were often held low, possibly resulting in better rates for consumer products like mortgages. But other consumer-related accounts are especially susceptible to any kind of rate manipulation. Pension funds were reportedly cheated out of millions when rates were held artificially low with the LIBOR manipulation.
Other banks: Now, it's unclear how far the scandal reaches, but for some banks, the manipulated rates may have cost them a lot of money. Wells Fargo (WFC 0.24%) and US Bancorp (USB 0.07%) are known to be more conservative with their operations. As the nation's largest mortgage originator, Wells Fargo makes most of its money from charging interest on those loans. With rates held low by the LIBOR manipulation, Wells missed out on increased interest income. Likewise, US Bancorp issues mortgages, car and student loans -- all of which would be affected by LIBOR rate changes.
Taxpayers: As the nation's mortgage guarantee firms, Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) are both affected by mortgage rates. But since the firms both have to invest money to generate profits, they are subjected to interest rate changes in multiple ways. According to one U.S. regulator, Freddie and Fannie may have lost out on $3 billion in interest payments due to the LIBOR manipulation. The losses would have stemmed from the groups' investments in floating-rate bonds. Taxpayers ultimately take the hit from the agency's losses, since the firms owe the U.S. government $137 billion.
This is not the end
As our economy continues to recover from the financial crisis, the banks aren't making it easy for Americans to forgive them for past wrongdoings. This rigging gambit has simply solidified common sentiment that bankers all graduated from the Gordon Gekko School of Business. The scandal has triggered major reforms to the LIBOR system, governmental oversight, and criminal charges for those involved -- but it's nowhere near resolved. Investors should hope for swift action to get the scandal settled and for banks to move forward with more honorable operations.
