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The LIBOR Scandal Is Bigger Than You Think

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Ordinary investors work hard to understand the basics of investing. For many of them, trying to get a handle on the myriad acronyms and frequent use of jargon by professional investors is more trouble than it's worth.

As a result, it would be easy for you to dismiss the recent scandal involving allegations that Barclays took steps to rig what's known as the LIBOR as something too esoteric to care about. But ignoring the scandal would leave you with the mistaken impression that LIBOR isn't important for average people. As millions of people are about to find out, nothing could be further from the truth.

LIBOR and you
LIBOR stands for "London Interbank Offered Rate" and actually refers to more than 150 different rates. You can find LIBOR figures for a variety of maturities between a single day and a full year in each of 10 different currencies, including the U.S. dollar, the British pound, the euro, and the Japanese yen.

The calculation of LIBOR is simple. Every day just before 11 a.m. London time, Thomson Reuters (NYSE: TRI  ) , which is the designated calculation agent for the benchmarks, receives information from the LIBOR contributor banks asking them at what rate they'd be able to borrow funds from other banks. It then calculates the appropriate LIBOR by looking at all the rates submitted, tossing out the top quarter and the bottom quarter, and then taking the average of the remaining figures. So if 12 banks submitted figures for a particular rate, the LIBOR would be the average of the middle six after eliminating the top three and bottom three.

LIBOR has a direct impact on many people. Those who have adjustable-rate mortgages often have their rates tied to an appropriate LIBOR benchmark, with mortgage rate resets based on changes in the LIBOR over time. Add in credit cards, car loans, and other credit, and the British Bankers' Association estimates that roughly $10 trillion in loans base their rates on LIBOR.

Looking past the obvious
As much as LIBOR influences ordinary people's lives, the much larger impact comes from the financial markets. LIBOR figures are used for an estimated $350 trillion in notional value of credit-default and interest-rate swaps. For instance, both Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) hedge their extensive borrowings using swaps tied to LIBOR. All told, more than $800 trillion in loans, securities, and notional derivative contracts has links to LIBOR. Those securities include interest-paying investments which pension funds and other institutional investors own, making for an indirect impact on tens of millions of workers and retirees.

Because of the pervasive use of LIBOR, the benchmarks take on huge importance not only in the interest rate market, but throughout the financial world. During the financial crisis four years ago, when LIBOR soared well above the prevailing Fed funds rate set by the Federal Reserve, analysts concluded that the credit markets had come to a screeching halt with banks afraid to lend to each other. Similarly, during flights to safety that push rates on Treasury bills to artificially low levels, LIBOR serves as another gauge that can provide a different perspective on the credit markets.

Who's involved?
With so much money involved, it's understood that the rate-fixing scandal is a big deal. Barclays is getting the lion's share of the attention, especially since CEO Bob Diamond resigned and the bank was fined $450 million by regulators in the U.S. and the U.K. for deliberately underreporting its rates for purposes of calculating LIBOR.

But more than a dozen other banks are under investigation to see whether they had a role in the scheme as well. Even though the rates are generated in London, Citigroup (NYSE: C  ) and JPMorgan have said that regulators are looking into their overseas practices, while reports include Bank of America (NYSE: BAC  ) in the mix as well.

The future of LIBOR
Unfortunately, the methodology for calculating LIBOR inherently relies on cooperation from the banks involved in the daily survey. Although changes in that methodology have made the calculation less susceptible to manipulation and increased accountability to some extent, LIBOR's accuracy nevertheless depends on the integrity of the banks that participate. As we've seen countless times in recent years, counting on banks to do the right thing is often a risky proposition.

Whether LIBOR fundamentally changes depends on what the derivatives markets demand. Whatever happens, though, will have lasting repercussions on the entire financial industry.

LIBOR will play a role in the political debate going forward as well, and that could have a big impact on the entire market. Learn more about the potential opportunities and threats that will follow the 2012 elections by reading the Fool's latest analysis on strategies to protect and increase your wealth -- regardless of who wins.

Fool contributor Dan Caplinger cuts through the jargon whenever he can. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital, Bank of America, JPMorgan Chase, and Citigroup. Motley Fool newsletter services have recommended buying shares of Annaly Capital. 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 Fool's disclosure policy cares about you.

Read/Post Comments (2) | Recommend This Article (18)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 05, 2012, at 9:52 AM, XMFSinchiruna wrote:

    It's the largest banking scandal of the 21st century:

  • Report this Comment On July 09, 2012, at 4:14 PM, trueprime wrote:

    All this hoopla and outrage over rigging the LiBor 5 or 10 basis points is really missing the elephant in the room.  The "Prime Rate" is really much more relevant to the U.S.  during the past 50 years.  Until more recently the Libor is not even in the picture in U.S. consumer credit. Most credit cards and consumer loans are/were more tied to the "prime rate" which was defined as the "the rate the banks charged to the banks' most credit worthy customers, such as the AAA companies".  Since the late 1980's the banks have been systematically rigging the prime rate by gradually increasing it over time so that it is now almost 300 basis points (3%) over the real "prime rate", i.e., what the banks really charged AAA companies such as Exxon and Johnson and Johnson.  This is the banks way of picking everyone's pocket without permission to the extend of billions and billions of dollars every year.  It is the biggest fraud in America.

    Our government and the Federal Reserve actually are part of this scheme in that they redefined the definition of "Prime Rate" in the official publications rather than stopping the banks from doing this. You can check this out just by looking at the old publications from the Federal Reserve Interest Rate Series vs. the current ones.

    Even attempts to correct this thru the legal system has been unsuccessful as the banks seem to have influence over the courts also (see Lum vs. Bank of America, et al).  If nothing else, the banks can outspend any legal challenger.

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