Explainer: What Is LIBOR?

The recent admission by Barclays Bank that it manipulated a key interest rate, the LIBOR or London Interbank Offered Rate, has raised questions about how state and local government finances have been affected in the U.S.

The manipulation is significant because the LIBOR rate is considered the benchmark for short-term interest rates across the financial system. Even a slight alteration in the rate has significant implications because it is used with hundreds of millions of dollars of debt offerings. 

Mayor Michael Bloomberg said on Thursday the city may have lost money due to rate tampering by large banks. But he doesn't believe the losses were large.

“If the rate went down, some city debt would be adversely impacted, and some city debt would be favorably impacted,” Bloomberg said. “If there are class action suits, we'll join ‘em, but it would be a de minimus amount of money.”

It was the first time the mayor has spoken on the subject since Barclays Bank admitted it tampered with the LIBOR.

New York Attorney General Eric Schneiderman and Connecticut Attorney General, George Jepsen are looking into the potential losses in their respective states.

James Freedland, a spokesman for Schneiderman, said, "Working together, the New York and Connecticut Attorneys General have been looking into these issues for over six months, and will continue to follow the facts wherever they lead."

Last week, Nassau County’s Comptroller, George Maragos, released an initial estimate of the county’s losses due to rate-tampering: $13 million.

What Is LIBOR?

LIBOR is the average cost of borrowing for banks and is used to price debt stock.

The rate is determined when banks submit borrowing costs. The top and bottom four are tossed out, and the rate is determined from the average of the remainder.

Because banks self-report, it’s possible for them to nudge the LIBOR up or down. And that’s what Barclays acknowledges some of its officials tried to do.

LIBOR matters because all kinds of other financial instruments are tied to it – for example adjustable rate home mortgages, and derivatives tied to government bonds.

What Are Interest-Rate Swaps?

For municipalities, one area where manipulating the LIBOR rate could have a major financial impact is through interest rate swaps.

When a government agency issues debt, it must repay the bond-holders of that debt the principal plus interest (often set at a floating, or variable rate).

To minimize the cost of borrowing, governments have increasingly turned to interest rate swaps. These are derivatives contracts made with a third party, for example, a bank. 

Under the swap agreement, a government issuing new debt might agree to pay a bank a fixed rate of interest based on the original principal on the bond.  At the same time, the government entity will collect money back from that bank at a variable interest rate often based on the LIBOR.  If the LIBOR drops, the government receives less money.  If it rises, it could receive more money.

The overall idea is to try to reduce the total amount of interest the government will pay over time to borrow money.

Not all swaps are tied to the LIBOR rate. There are many other benchmarks out there, though LIBOR is among the most common.

How Is Our Area Affected?

It’s hard to say. Most debt-issuers are still examining their own potential risks, and are saying little. But the size of swaps agreements is a good starting point:

  • The Metropolitan Transportation Authority has swaps on about $3 billion of debt.
  • The State of New Jersey - $2.8 billion
  • New York City - $2.58 billion
  • New York State - $2 billion
  • The Port Authority of New York and New Jersey - $460 million

These dollar figures don’t reflect potential losses. They are the principal amounts on which interest rate payments may have been erroneously calculated. So any losses would likely be much smaller.  And not all swaps are tied to the LIBOR. 

Since the financial meltdown of 2008, debt issuers have generally turned away from interest rate swaps, but there are still plenty of swaps arrangements outstanding.

Andy Pratt, a spokesman for New Jersey’s Department of Treasury, said the Garden State’s potential losses are much diminished today, compared with a few years ago.

“We have greatly reduced the number of swaps from the levels entered into by previous administrations,” Pratt said, “and we have greatly reduced the risks tied to indices like LIBOR in our remaining portfolio.”

A coalition of labor groups recently reported that public transit fares are rising across the country because transportation agencies (including the MTA) signed ill-advised swaps agreements in better economic times.

The MTA’s swaps, this study says, are now costing riders $114 million a year.

The MTA strongly disputes that finding. "Our synthetic variable-rate debt is performing as expected, delivering interest rates almost 1 point below what comparable fixed-rate debt would have cost us," said Adam Lisberg, a spokesman for the transit agency.

Over the past decade, swap agreements became more common and more complicated.  Jefferson County, Alabama, became the largest municipal bankruptcy in U.S. history when its swap arrangements left it with debts it could not pay.

Justin Marlowe, assistant professor of public affairs at the University of Washington, said swaps’ mixed track record does not mean government should never use them.

"Like any tool, which is really what these are, that tool can be properly used or improperly used,” Marlowe said. “And where swaps were properly used, they saved the public money. In other circumstances they did not. As a general rule the tool can be quite useful under the right circumstances."