Tags: Libor | Banks | Towns | scandal

Libor Matches Big Investment Banks Against Small Towns

By    |   Wednesday, 25 Jul 2012 08:45 AM

The latest bank scandal is difficult to understand at first glance. The London Interbank Offered Rate (Libor) is in the news as regulators try to determine whether or not global banks lied about the interest rates they were paying.

Banks and investment firms allegedly reported lower rates for loans than they were actually paying. This made the financial firms appear to be in better shape than they were, which helped hold down interest rates. Billions of dollars in loans, including many small business loans and almost all reverse mortgages, are tied to Libor.

Low rates should have benefited consumers, but it seems illogical that banks would ever do something that benefits consumers at their own expense. There must be a loser, and it turns out it is the consumers who pay local taxes.

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Banks held derivatives tied to Libor. By deflating rates, the banks enjoyed wins on those derivatives, many of which were sold to local governments, which in turn issued municipal bonds. Cities often chose to issue variable rate bonds with a derivative contract, which guarantees the interest paid will always be less than the fixed rate would have been.

Investment banks received fees on both the bonds and the derivatives. After a few small lies, they now have larger gains on the derivatives than the market would have provided.

Small lies boosted the cost of the derivatives for cities at the expense of the big investment banks. Truthfully, the city budget managers lacked the information needed to make a trade that could beat the biggest firms in the world.

This scandal should not come as a surprise to anyone who knew small towns and cities were making trades in a zero-sum game with the sharpest traders in the world.

Unfortunately, taxpayers did not know what their governments were doing.

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Wednesday, 25 Jul 2012 08:45 AM
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