A report that theU.S. Department of Justicehas opened criminal investigations into allegations that Wall Street's biggest banks conspired to rig interest rates tied to trillions of dollars in investments should hearten Baltimore City officials who have filed a related civil suit. It's still too early to know whether Baltimore can force Wall Street to repay the millions of dollars in losses it claims to have suffered, but as the lead plaintiff in a case involving hundreds of investors who believe there were bilked by the alleged scheme, the city is right to make every effort to hold the perpetrators accountable.
Readers may be forgiven for feeling put off by the seemingly Byzantine complexity of the issues raised by Baltimore's lawsuit. As the The Sun's Steve Kilar reported Sunday, the operations of the big banks and the arcane financial instruments they use to create value for investors involve a bewildering array of mechanisms that potentially lend themselves to abuse. But the basic outlines of the case are clear.
A decade ago, the city issued a series of municipal bonds to raise money for new parking infrastructure, water utilities and other projects. To attract investors, the interest on the bonds was tied to a benchmark rate called the Libor, which stands for London Interbank Offered Rate. Libor is a floating interest rate that describes what banks expect to pay to borrow money from each other, and it is calculated daily based on reports the banks submit to their trade group, the British Bankers Association.
Baltimore's suit alleges that the big banks on whose reports Libor is based conspired to manipulate the rate by systematically understating what it would cost them to borrow. By doing so, the banks made themselves look more creditworthy — and hence financially stronger — than they actually were. Moreover, by keeping interest rates artificially low, they had to pay out less to their depositors and to investors who bought bonds whose interest rates were tied to Libor.
To guard against a sudden uptick in the interest payments if its bonds tied to the Libor were to rise unexpectedly, Baltimore bought financial instruments called fixed interest-rate swaps that obliged the banks to pay investors the higher rate instead. In return, the city agreed to pay a fixed rate to the bank that was slightly higher than the expected value of Libor. That way, the bank made money when Libor was low, while the city's fixed-rate swap served as a kind of insurance policy against rates suddenly rising.
As long as the Libor-pegged rate remained lower than the fixed rate the bank charged the city, the banks made money because what they paid out in interest to investors was less than what the city was paying them on its fixed-rate swap. And the larger the difference between the Libor-pegged rate and the city's fixed rate, the more money the banks made.
That's why the city claims it lost money when the banks colluded to artificially lower Libor. By holding Libor down, the banks increased their own profits by charging the city more interest than it should have paid to protect itself against a sudden increase in rates. Put another way, the banks sold the city an insurance policy based on the risks assumed for a teenage driver living in a high-crime area, when in fact the chances of Libor rising above the city's fixed-rate swap were closer to the likelihood of a middle-age couple from the suburbs getting into an accident.
In order to win, however, the city not only will have to prove that the banks conspired to rig Libor but also show what the rate would have been had it not been pegged at an artificially low level by the banks. The difference between the two is what the city hopes to recover, and given the more than half billion dollars in bonds the city issued it could add up to millions of dollars.
The banks deny they colluded to set interest rates artificially low, but that argument has become less convincing since last month's $450 million settlement between the Justice Department and Barclays bank involving similar allegations of rate-rigging. In the Barclays case, the bank admitted manipulating the reports it submitted to the trade group that sets Libor, and it claimed moreover that it could not have done so without the complicity of its American counterparts on Wall Street, including JPMorgan Chase, Citigroup and Bank of America. Barclays is now cooperating with the Justice Department to detail its collusion in rigging the market.