Is The LIBOR Mortgage Finished?

Barclays Bank PLC — the huge British bank — has agreed to pay more than $450 million in fines for efforts to manipulate the LIBOR rate. Now an enlarged investigation is underway, one which could involve the pricing of U.S. mortgages.

The “LIBOR” is the London Interbank Offered Rate, an interest index set by several British lenders based on the estimated cost to borrow from one another. Barclays is one of the banks that set the LIBOR rate, and the bank has now been fined for trying to fudge the numbers.

The U.S. Commodity Futures Trading Commission fined the bank $200 million because “Barclays attempted to manipulate interest rates and made related false reports to benefit its derivatives trading positions.”

The Justice Department got $160 million to “resolve violations” associated with the LIBOR. It said Barclays “improperly took into account the trading positions of its derivative traders, or reputational concerns about negative media attention relating to its LIBOR submissions.” Justice also says criminal investigations into LIBOR manipulation “by other financial institutions and individuals is ongoing.”

Meanwhile in Europe, Britain’s Financial Services Authority fined Barclays £59.5 million for LIBOR-related “misconduct.” The British fine is equal to roughly $93.2 million.

Among other things, the LIBOR is widely used in the United States as an index for adjustable-rate mortgages.

If rates were artificially too high then the end result would be steeper monthly costs for ARM borrowers. For some borrowers higher rates would mean unaffordable monthly costs and even foreclosure. Are borrowers due money for index overcharges? And is a lawyer somewhere wondering if artificially inflated interest costs could be seen as the basis for wrongful foreclosure claims. 

But imagine if LIBOR rates were artificially reduced. That would be good for mortgage borrowers — but not so good for mortgage investors, a very potent group with lots of lawyers.

Of course, where there are rates there are also side bets to “limit” risk so if the index is manipulated then side bets can also be impacted. This gets us into the strange world of derivatives. Were such bets impacted by LIBOR manipulations?

The day after the Barclays’ fines were announced Bloomberg Businessweek reported that “Barclays Plc (BARC), Royal Bank of Scotland Group Plc and Britain’s two other biggest banks will compensate small and medium-sized businesses improperly sold interest-rate derivatives following a probe by the U.K. financial regulator.”

Any problems with derivatives trading could get into very big numbers.

Britain’s FSA says the LIBOR is used as a benchmark reference rate to trade such things as Euros and dollar derivative contracts. In the first half of 2011 such contracts had a total notational value of $554 trillion. Really — trillions of dollars.

The contracts are supposed to offset one another to even out risk but it’s obvious that not every transaction is balanced — just look at JPMorgan Chase which has been much in the news because of a trading shortfall. The loss was first reported as being about $2 billion but according to the The New York Times could now amount to as much as $9 billion.

Meanwhile, it will be interesting to see if lenders and borrowers move away from LIBOR-based ARMs. Indexes based on Treasury securities and the 11th District Cost of Funds Index are readily available and could easily be used instead of the LIBOR.

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