What if Libor Manipulation Helped Save Homeowners?

Did the banks alleged rate rigging help millions of homeowners avoid defaulting on their mortgages, and keep them in their homes?

Or did the banks’ rate rigging cause mortgage rates to soar before the financial crisis?

At the heart of the Libor scandal lies a conundrum:

If banks joined Barclays in artificially lowering a key interest rate used to price all sorts of consumer loans and securities during the depths of the financial crisis, that move not only made the banks look better, but it also helped those who had loans at the time tied to Libor.

For instance, Libor spiked over a three-week period starting Sept. 15, 2008, from 3% to 4%. That move higher occurred after Lehman Brothers crashed. The Reserve Primary Fund then broke the buck because of the losses it suffered on Lehman commercial paper. Investors then ran to the sidelines, the interbank lending market froze and banks and financial companies started to hoard cash, causing Libor to soar.

That had analysts at Citigroup at the time predicting that a sustained continued move higher could lead to a scary 10% rise in mortgage defaults and an 18% rise in adjustable-rate payments for the average subprime borrower. It appears Citigroup feared the rising short-term Libor rate would cause the longer term six month Libor rate to rise, too. Mortgages are tied to the longer six-month rate.

At that time, Citigroup said that about two-thirds of all adjustable mortgages were pegged to Libor at that time

But then Libor plunged, as economic activity ground to a halt. And lower Libor rates may have helped homeowners ever since by keeping mortgage payments down.

Of course, the flip side of that argument is that homeowners could have been – and may now be – paying an artificially higher rate if banks have compensated by artificially raising Libor now.   And maybe that’s how Americans will sit up and take notice of the Libor rate-rigging controversy.

The Financial Times has reported that at least 900,000 U.S. mortgages originated from 2005 to 2009 were indexed to Libor, citing data from the Office of the Comptroller of the Currency, a U.S. bank regulator. Those mortgages carry an unpaid principal balance of $275 billion, and equal about 3% of mortgages originated during that time.

To date, the Barclays scandal, which comes with embarrassing e-mail disclosures, show that there were no attempts to rig six-month Libor rates. Instead, allegations are that the one-month and three-month Libor were manipulated, not six month Libor, the benchmark used for adjustable mortgages.

At minimum, proving collusion is like trying to hit a soup bowl fifty miles out in space with a five-iron and a golf ball. Bank regulators will have to prove the rate rigging took place on the exact same day the banks reset all of these mortgages, and all to higher rates.

It is likely easier for the banks to try to nail Wall Street con artists who sliced and diced and repackaged rotten subprime loans into securities sold to pension funds and sovereign wealth funds. No perp walks yet on that.

Still, the short-term Libor rate rigging affects short term securities and derivatives—if yields were driven lower, that means the banks that sold these securities didn’t have to pay as much yield to, say, money funds owned by, say, state or city pensions.

The only thing that’s certain about the Libor rate-setting kerfuffle is a cultural one.

Panel banks who volunteer rates for Libor did not have to always base them solely on actual transactions in each of the currencies, securities or maturities for which they provided quotes.

Instead, practice has been to let panel banks use historical transactions to give their guesstimates about what are the proper borrowing rates in markets that have been iced over or dormant, such as the distant dusty corners of currencies markets, i.e. forward currency options on the Danish krone or whatever.

Problems with that practice came to the fore when the interbank market collapsed and dried up during the 2008 crisis. Then the controversy became whether these rate-setting practices were increasingly unmoored from reality—or at minimum based on transactions from antiquity.

Perhaps the overall issue is this controversy shows there is something wrong with the Libor culture.