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The Deep Back Story of Liborgate

In the last four years costly interest rate swaps have become a focus of community activists and public sector unions who have watched as literally hundreds of millions, perhaps billions have been drained from the public sector. Until recently activists trying to address this crisis have been pressuring elected officials and banks, using the logic that it was the Federal Reserve’s reduction of rates that caused most swaps to turn toxic. However, because Libor is the key rate with which the majority of interest rate swap payments are calculated today, the Libor scandal has reinvigorated and transformed the moral and legal arguments that can be used by local governments seeking exits from toxic swaps. Any manipulation of Libor rates since 2007 means that swap counterparty payments linked to hundreds of trillions in public debts have been distorted, potentially to the detriment of the public, all of this on top of the already unjust depression of rates caused by the Fed. Even the stolid Financial Times has made note of this, saying that local governments burned by swaps and seeking an exit “have a point,” and that “A groundswell of such resistance should worry other banks”.

Right now there are hundreds of are accountants, researchers, and lawyers picking through paperwork and audio tapes to advance both government investigations as well as civil lawsuits against the banks that screwed with Libor. It’s going to take many long hours auditing swap payments over previous years to determine if and how the manipulation of Libor damaged specific localities and public agencies, however.

The activists I’ve spoken with who are fighting swaps in California are keenly following how the Libor scandal unfolds. The most watched arena is the Justice Department’s investigation, but there are multiple federal agencies, and foreign agencies looking into Libor. In Oakland activists have even asked their City Attorney to consider how their city can jump aboard Libor litigation that has been spearheaded by the city of Baltimore and the Hausfeld law firm.

There’s a deep back story to the Libor-municipal interest rate swap connection, part of which I’ll attempt to tell here. There’s also an important theoretical point to be made about interest rates.

First there’s the issue of why municipal interest rate swaps —instruments that were purportedly meant to hedge public debt— were ever pegged to the Libor rate in the first place. Libor, after all, was created as an index for financial transactions in the private sector, not for large public entities. In fact, when interest rate swaps were first becoming popular finance tools for cities, school districts, and public utilities, the floating rate index that was used to calculate the variable payments of the bank counterparty to the public agency were compiled from a very different and much more reasonable source – a large pool of traded public variable rate debt obligations – not Libor. In other words, the first variable index rate that swaps were calculated with was literally a measure of the average price at which major U.S. public debt was trading in the market.

This differs from Libor in two key respects. First, it’s not a hocus-pocus interest rate created by a handful of bankers out of thin air that everyone else is supposed to trust. The process was different and more approaching the ideal “markets” lionized by neoclassical economics. Prior to Libor’s dominance, the floating rates for municipal swaps were actually a measurement of a market rate. This market wasn’t entirely free of information asymmetries or big players who could swing the movement of capital by fiat, but it did mean that it was much harder for any participant to manipulate rates because they’d have to either create an incredibly enormous conspiracy of parties trading public bonds, or they’d have to try to corner a huge part of the public debt market – both very unlikely (but similar things have been done in the past). For previous rates that swaps were tied to there was more of a “market” process by which a plurality of competing parties create the rate out of a chaotic process of bidding things up and down. SIFMA’s spokespeople recently underscored this point, calling their index a “market-driven rate” as opposed to the “bank-driven” Libor.

Second, the indexes by which municipal interest rate swaps were previously priced differed in the sense that they actually were measuring average floating rates attached to public debt, rather than rates attached to variable rate debt in the private market. This real attachment to public debt made perfect sense because municipal buyers of interest rate swaps were intending to hedge against these very rates attached to their bonds and notes trading in the market.

The first index measuring public variable rate debt obligations was called the PSA Municipal Swap Index. This later became the BMA index, and later still the Securities Industry and Financial Markets Association, or SIFMA index. SIFMA, the Securities Industry and Financial Markets Association index is still around today and is used by many public agencies to price swaps.

However, by the early 2000s, Libor was eclipsing the SIFMA index as the dominant rate by which interest rate swaps for public agency debts were calculated. This triumph of Libor was due to the marketing efforts of the big banks and the financial advisers who were in the business of selling swaps to cities and public agencies. The banks promoted Libor as a superior index due to its greater liquidity, and they told public officials that by adhering to Libor they could get a better rate, thereby boosting their savings on bonds hedged with the London rate. Don’t be stupid and timid, they told public officials. The cheaper rates and bigger markets are available through Libor, and they’ll save you millions.

A 2003 report  by CDR Financial Products explains the reasoning of the advisers and bankers who pressured cities to switch over to Libor:

“[U]tilizing the BMA index for swaps introduced its own problems: 1) The BMA municipal swap market is relatively illiquid. 2) The index is reset only once a week. 3) The hedging costs tended to be fairly high. Recognizing that the BMA index tended to track 1-month LIBOR (as can be seen in Chart 1), industry participants began using a percentage of LIBOR as a hedge instead of BMA to address these issues.”

What CDR’s finance gurus meant by the fact that BMA (now SIFMA) “tended to track 1-month LIBOR,” was that if you plot the long term variation of BMA to 1-month Libor, you’ll see a pattern in which they swing up and down with one another, and you’ll also notice that the spread, the amount by which they differ, has also tended to remain about the same over long periods. Almost.

By clipping 1-month Libor down to about 65 percent of its normal amount, financial analysts were able to claim that they had created a rate that was essentially equivalent to the BMA index. They were about the same rate, and would swing up and down at about the same time through the normal business cycle of the global marketplace. Almost. Discrepancies were temporary and ultimately not that important said the financial industry to public finance officials.

Replete with fancy models that demonstrated Libor’s ability to produce superior swaps that would hedge cheaper bonds, CDR Financial and their colleagues in the municipal finance advising business, as well as the big banks like JP Morgan Chase, Bank of America, and Goldman Sachs were able to convince cities to make the big switch from BMA/SIFMA to Libor.

The only serious reservation CDR Financial, and similar firms, all of who were about to make millions off the new Libor denominated municipal swap market, disclosed to cities and public agencies was that they should beware the “basis risk.” Basis risk, quite simply, is the obvious realization that Libor isn’t tracking the same thing as the BMA/SIFMA index, and Libor isn’t influenced by the same set of forces as BMA/SIFMA. The variable rates attached to public debt are quite different than the variable rates attached to bank and corporate debts. Libor doesn’t actually equal 60 to 70 percent of SIFMA. It only did this for a specific historical period. Explanations of why these indexes tracked one another rather neatly were nothing more than theories. But these warnings were delivered as an afterthought, as nothing to seriously worry about.

This is what CDR Financial told their clients:

“’Basis risk’ consists of the potentially large and damaging spread between the yield of the VRDO [the actual interest rate payments on bonds] and the percentage of LIBOR [the amount a local government would recieve from their bank counterparty that was intended to cover the VRDO on the bonds]. Over the past two years, these fears have come to fruition. The relationship between BMA and LIBOR appeared unstable; BMA as a percentage of LIBOR has increased steadily to a 52-week average of almost 85%. This has caused concern and economic hardship among issuers and spurred a desire to understand the true nature of the relationship between BMA and LIBOR.”

An especially interesting thing about the CDR Financial report cited above is that it was written by criminals. David Rubin, CDR’s president, pleaded guilty last year to federal charges that his firm stole millions from local and state governments and government agencies by rigging the bids on countless municipal derivatives contracts.

CDR’s participation in a conspiracy to defraud governments is a small part of a huge conspiracy involving dozens of big banks, financial advisers, and brokers. Rubin’s conviction was part of a sweeping Justice Department investigation of bid rigging in the municipal derivatives market. What Rubin and others essentially did was to steal millions from local governments by reducing the interest rates governments received on financial contracts like guaranteed investment contracts (GICs), specialized short term investments where cities, school districts and other public agencies park their bond proceeds between the time they receive them, and the time they actually spend them. GICs and other municipal derivatives are meant to keep bond money safe from inflation in the several years it often takes to spend it. Rubin and his friends stole public money by driving down the interest rates that cities were getting for essentially loaning their money to the banks, pocketing the difference.

Back in 2008 a number of cities such as Baltimore and Oakland, and later public agencies like the Sacramento Municipal Utilities District, filed suit against CDR and their co-conspirators. Among the dozens of other defendants are AIG, Bank of America, JP Morgan, Morgan Stanley, UBS, Well Fargo, but also “un-named” defendants that could include other major financial companies. Thebig consolidated class action case against the financial industry led by major cities and public agencies is known as In re: Municipal Derivatives Antitrust Litigation MDL 1950. It’s as about a scandalous example of major financial corporations using their power to steal public dollars by manipulating interest rates, but unlike the Libor scandal it has yet to garner as much attention from the U.S. press. Hopefully this will change as the Justice Department’s investigation, and the civil suit proceed to uncover the truth.

While CDR’s Rubin and his buddies didn’t get busted for anything directly related to the Libor manipulation, and while we’re just now only learning the full extent of the Libor scam, firms like CDR Financial were instrumental in convincing public officials to adopt Libor as the dominant rate attached to their interest rate swaps. Pehaps Rubin didn’t know Libor would become another tool used by banks to vacuum up public dollars on the sly, but Rubin and his buddies did know the general tricks of the trade.

The basis risk described by Rubin was well known when governments were adopting Libor, but the fact that the major banks that create Libor were possibly manipulating the rate to boost their balance sheets wasn’t known, and it does mean exactly what many commentators have already said – the public was cheated out of untold millions during the period of the fraud. In hindsight a lot of commentators are noting how the switch from SIFMA to Libor for municipal interest rate swaps created a lucrative arbitrage opportunity for bankers willing to bet on how the spread, the difference between the Libor rate and the actual variable rates on the underlying bonds the swaps were supposed to hedge, would move over time.

Whatever the causes of basis risk prior to the time period of the Libor conspiracy, the widening of the spread between Libor and and the actual variable rates attached to government bonds has costed the public huge sums of money. Now that we are confronted with the fact that Libor itself was prone to an easy act of manipulation by the few global banks that create it, is it fair to suggest that the banks fiddled with the rate during the financial crisis, or previously, on various occasions to produce a beneficial spread in municipal derivatives markets from which they could harvest vast sums of wealth in a manner that was almost unnoticed?

By convincing so many local governments to switch from BMA/SIFMA to Libor, firms like CDR Financial exposed local governments to the totally new problem of purposeful manipulation of the Libor rate to change spreads between variable rates attached to bonds, and the percentage of Libor agreed to in swap contracts meant to hedge these bonds.

The big switch from SIFMA/BMA to Libor points to something that’s worth talking about in more detail – the inherently political nature of interest rates.

One of the biggest problems with the reporting and commentary on the Libor scandal is the frame of “fraud,” which has guided the whole discussion. News reports and analyses have emphasized over and over again how employees of the banks that provide quotes to produce the various Libor rates criminally violated the rules. On one level this is all true, and it needs to be tracked and explained to the public so that those most responsible are shamed and made to pay for their transgressions. However, there’s a way in which this frame actually does harm to our understanding of banking and finance.

The “fraud” story, if that’s the only one we tell about Libor, leads to a very constrained debate about the concept of interest rates and the political economy of finance. We need to analyze the Libor scandal from a more historically informed position that recognizes key interest rates for what they are and always have been – privileged claims that powerful capitalist organizations make on the social production of wealth.

It has been noted that Libor was pretty much a conspiracy from its very beginning. It was never a “market-determined” rate in which actual loan prices were compiled into objective quotes. Libor was always a club of powerful banks inventing the price of money, and expecting that other banks, corporations, and even sovereign states would accept their word.

But is this really any different from any other rate of interest, be it another consortium of banks in a given market, or the rates provided by central banks? It’s hard to actually point to any interest rate ever utilized in history that was truly a product of “the market,” meaning a product a plurality of competing lenders and borrowers in which no single party, or conspiracy of parties, can significantly influence rates in their favor. Conspiracy, influence, and power are more the norm.

The actual history of finance provides countless examples of how different interest rates have been determined. Major factors in the production of interest rates have always included the power of large banks, state economic policy, wars, and central bank decisions, among other means. Small groups of especially powerful capitalists or state bureaucrats have always conspired to sabotage economies in order to direct flows of wealth to themselves or their allies.

This isn’t to say that there aren’t macroeconomic factors that generally drive rates of interest up or down. Certainly there are constraints within which the most powerful economic agents even have to operate. However, the notion that there is such a thing as a “fair market” rate of interest, and that the Libor scandal represents a criminal violation of this objective force doesn’t hold water. The Libor scandal is simply the latest example of a much longer-running phenomenon by which wealth is accumulated by those powerful enough to lift or sink rates at key moments.

Darwin Bond-Graham is a sociologist and author who lives and works in Oakland, CA. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion, forthcoming from AK Press.

A shorter version of this article appeared in Dollars and Sense.

More articles by:

Darwin Bond-Graham is a sociologist and investigative journalist. He is a contributing editor to Counterpunch. His writing appears in the East Bay Express, Village Voice, LA Weekly and other newspapers. He blogs about the political economy of California at

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