Interest Rate-Fixing Scandal Swindles Baltimore, Other Municipalities out of Millions of Dollars

Amidst the financial crisis of 2008 and resultant recession, cities and states around the country lost millions of dollars on investments tied to the London Interbank Offered Rate (Libor). Far from a “free market phenomenon,” they say the rate was suppressed by a cartel of some of the world’s largest banks, and the city of Baltimore is taking them to court.

TRANSCRIPT:

NOAH GIMBEL: I’m standing in front of the headquarters of the Washington Metropolitan Area Transit Authority in Washington, DC, where administrators have recently announced a new round of fare increases following a massive 2010 hike that pushed rates up as much as 33%. Similar stories abound throughout the country – from Boston to San Jose, New York to San Francisco. In 2011, rate hikes cost DC public transport riders over $109 million, and much of that money is going straight to major Wall Street banks. But only recently have observers begun to find out why. According to a recent report from the Refund Transit Coalition, more than 100 government units nationwide – transit agencies, pension funds, and municipalities – are currently tied into more than 1,100 different debt-swap-deals with major banks. And a large portion of those deals pegged the interest rates paid out to public-sector investors to the London Interbank Offered Rate, or Libor. Ongoing investigations into Barclays and other major financial institutions have found that banks conspired to manipulate Libor as far back as 2005, resulting in massive profits for some insider-traders and massive losses for thousands of investors around the world.The city of Baltimore is taking all 19 of the banks responsible for setting Libor to court, alleging that the suppression of Libor lost the city millions on its debt-swapping agreements.To explain how these agreements work, the Real News spoke with Peter Shapiro, head of the Swap Financial Group. His firm is the leading swap advisory firm in the country, and has had the city of Baltimore as a client for about a decade.

SHAPIRO: Public agencies in the US, one of their responsibilities is building and maintaining infrastructure. Whether we’re talking about a city government like Baltimore, or a transportation agency or an airport authority, they all have big capital plants. They borrow all the time, the cost of capital, the cost of borrowing, is a big ingredient in their cost. They could borrow using conventional fixed-rate bonds, by issuing normal municipal bonds, tax-exempt bonds, at one rate, or they could use a swap to produce a significantly lower rate in most markets. Most big cities that do swaps, which is probably 75% of them, have swap advisors, and we advise most of the very biggest cities, the ones that are bigger than Bmore – NY, Chicago, Houston, Philadelphia are all customers.Here’s how it works – instead of issuing normal fixed-rate bonds, they issue floating-rate bonds. Those floating-rate bonds are bought by investors who eagerly gobble them up, and they receive a floating rate of interest from the city, and that obligation from the city is directly to the bondholders, it’s an absolute pledge. The swap is separate from that. They enter into a separate agreement, a swap agreement, with a bank. It has nothing to do with the obligation they have with the bondholders, except it helps to convert the financial obligation they have to live with from a floating rate into a fixed rate. They don’t really want to be on the hook for a floating rate because they’re volatile – they go up and down unpredictably. They’d prefer to be in fixed-rate form, but they want to do it cheaper. By entering into the swap, the bank will pay them a floating rate, and that floating rate can be used to offset the floating rate they have to pay to the bondholders. And in return for getting that floating rate from the bank, they pay the bank extra. Think of it as three flows: a floating rate paid by the city to bondholders, a floating rate received from the bank on the swap, and a floating rate paid to the bank on the swap. If you have two floating rates – one in, one out – they’re supposed to neutralize each other, and what you’re left with is the fixed rate. And that fixed rate is typically 50-100 basis points lower than the fixed rate they’d be paying in the conventional fixed-rate bond market.

GIMBEL: When banks conspired to keep the Libor rate artificially low, the Libor-based rate cities received from banks on swap deals shrunk well below the fixed-rate they had agreed to pay out to those banks.The libor-based flow from the banks to the cities also frequently dropped below the floating rate they owed to municipal bondholders. That’s because many of the floating-rate bonds issued by municipalities to fund public infrastructure development were based not on Libor, but on a different rate called SIFMA set by the Securities Industry and Financial Markets Association. As seen here, SIFMA – the blue line on the graph – jumps considerably higher than libor at the peak of the financial crisis in 2008, meaning big losses for cities in the swap market.But while the cities may have lost out on these deals, according to Shapiro the banks didn’t necessarily win.

SHAPIRO: It doesn’t matter if the floating rate is lower. The bank doesn’t make any more money off that. When the bank entered into the swap originally, when they first did it, they enter into an offsetting hedge which replicates the exact positions on the opposite side. In effect, what they do: Baltimore enters into a swap with a bank, and is paying the bank 4% in return for receiving Libor. The bank has another counterpart on the other side, where the bank is paying that counterparty 3.9% or 3.85% and receiving Libor from that counterparty. They run what’s called a “matched book” – they’re required to do that. They need to offset every trade when they put it on. What they do is they book that spread between the 4% and the 3.9 or the 3.85. They book 100% of the profit on day 1 for the entire life of the trade, even if it’s a 30-year trade. And it makes no difference if floating rates go down.

GIMBEL: Of the five banks with which Baltimore had swap agreements, three – JP Morgan Chase, Deutschebank and UBS – sit on the board that sets Libor. But most commercial banks stood to gain from the artificial suppression of the rate.To author and political economist Tom Ferguson, the swap deals were downright predatory.

FERGUSON: I can’t imagine why a rational being would sign, what was supposed to be an insurance policy that has you just shoveling out millions of dollars in the case of a decline in rates. It looks to me like the same type of deal that you got with the mortgage story where all kinds of predatory deals were made.I am quite struck too by this: A lot of people bought floating rate notes, got hosed, made the claim successfully that these were in effect predatory and they got out of it one way or another after 2008. I’m quite struck by the differential in application and treatment: Public sector prey don’t do much when they get hosed. When the private sector folks lose money they go back to the people that sold them and say buy this thing back or we’re never gonna do business with you again. I don’t know of a single case of that happening in the public sector, and it makes me think that the whole process of decision making there is a little weird.They may not want to admit that they made a bad decision to begin with, and they managed to keep it secret with what seems like the tacit collusion of the press… But then the daily papers almost everywhere, they didn’t cover it. And in the libor case, banks are accused of pushing the rate down artificially, and there’s no question you can see it in the financial services authority in Britain, these people were talking about how derivative settlements could be made more favorable to their banks by pushing the rates down. It’s right in cold print. And that’s just a sample of this. These people were doing this for a long time. The official story was from 2005 on. But Libor had problems going back even in the 90s. We’ll have to see how much this opens up.

GIMBEL: And the only way for the case to open up is through thorough investigation. The consequences may be enormous, and we’ll explore them in the next part of our series. For the Real News, I’m Noah Gimbel in Washington.