Libor scandal for dummies

This post comes from Stacy Johnson at partner site Money Talks News.

When you see criminals like Bernie Madoff doing a televised perp walk, two thoughts probably come to mind. The first is "What was he thinking?" The next: "I'm sure glad that didn't happen to me."

In recent weeks, a scandal has been unfolding that could potentially make the Wall Street Bernie look like Sesame Street Bernie. And yet, despite the trillions of dollars involved, the sheer audacity of the fraud, and the irony of so many leaders clamoring for less bank regulation -- Mitt Romney, along with many in Congress, have called for repeal of the Dodd–Frank Wall Street Reform and Consumer Protection Act -- there hasn't been much in the mainstream media about Libor.

Other than the name, the Libor scandal isn't all that complicated. In the video below, I ask a finance professor to explain it in simple language. Check it out, then meet me on the other side for more.

How Libor works

You probably don't think much about where interest rates come from. On everything from credit cards to savings accounts, you're presented with a rate, then you simply decide whether to take it or not. Whether you're borrowing or investing, you logically assume the rates you pay or earn are set by competition.

But as you learned in the video above, interest rates on trillions of dollars worth of financial products start with a benchmark called the London Interbank Offered Rate, or Libor.

While the label makes it sound complicated, it's just the average interest rate big banks pay to borrow from each other. It's called "London" because it's computed in that city. But that's misleading, because it affects interest rates worldwide on some (but not all) adjustable-rate mortgages, credit cards, and student, car, and other types of loans. In addition to loans, it's also used to set rates for institutional investments -- the kind that mutual funds, pension funds, and government agencies might use to earn interest on short-term investments.

What's the problem?

Libor isn't set by supply and demand. It's not set by the market or the government. Instead, it depends on the banks involved (including giants like Citibank, JPMorgan Chase, Bank of America, and Barclays) to accurately report the interest rates they'd have to pay to borrow from each other. The highest and lowest rates are thrown out, the rest are averaged, and Libor is set.

So Libor depends on honesty. If banks don't tell the truth, Libor won't be accurate -- nor will the interest rates on trillions of dollars worth of loans and investments.

Why would they lie?

Banks would lie about the rates they'd pay to borrow for two reasons.

• The first is to make themselves seem stronger than they are. As with you and me, if a bank is a good risk, it will pay less interest. So if a bank reports that the rate it pays to borrow from other banks is low, the financial world will think it's strong.
• The other reason a bank may want to lie about what it costs it to borrow is to make money. Major international banks do more than lend. They also trade stocks, bonds, and all kinds of other investments for the same reason any investor does: to make a profit.

Traders working for banks participating in Libor could simply buy an investment that goes up when rates fall, then lie about their rates in an attempt to lower Libor. In short, they could manipulate the market and position their investments to make money, essentially trading on inside information. This is especially true if banks magnified the impact of their reporting by colluding with one another.

How does it affect me?

If Libor was manipulated, the results could be far-reaching. Since Libor is the benchmark for many other rates, an inaccurate Libor means millions of people all over the globe might have paid more or less interest than they should have. If rates were artificially low, borrowers for things like adjustable-rate mortgages and student loans would have benefited. But investors like cities, mutual funds, and pension plans may have earned less than they should have.

The extent and impact of Libor manipulations is still unknown. The effect on the average consumer is probably small, but as the professor in the video above said, it could be measurable to people with large loans tied to Libor, like those with adjustable-rate mortgages.

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What's happened so far?

In late June, Barclays agreed to pay $450 million to settle accusations it had lied in an attempt to manipulate Libor. Other banks participating in Libor are now under investigation, with many experts predicting more banks will be writing similar checks in the days ahead.

What should I do?

First and foremost, be mad.

Be mad that you're expected to play by the rules in a system where the biggest players don't. Be mad at regulators who didn't properly regulate. Be mad that making billions in profits isn't enough for some financial institutions; they have to game the system to make even more. And be suspicious when you hear someone insisting banks are over-regulated.

More on Money Talks News and MSN Money:

• The 10 golden rules of scam prevention
• 8 steps for a mid-year money checkup
• 18 tips to give your credit score a boost
• Wall Street is ruining America
• Disgusted with JPMorgan
• Libor scandal mushrooms