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Changed by Wall Street, for Wall Street

nytimes.comJuly 30, 2012

By Gretchen Morgenson

AND so Liborgate drags on and on and on.

Last week, two senior Washington officials — Timothy F. Geithner, the Treasury secretary, and Gary Gensler, the head of the Commodity Futures Trading Commission — testified before Congress about the scandal surrounding Libor, the benchmark for global interest rates.

No great revelations were forthcoming.

As we await the full story, it’s worth remembering how Libor, the London interbank offered rate, became the world standard to begin with.

You probably won’t be shocked to learn that in mortgages, at least, Wall Street played a role in pushing Libor over another rate benchmark — one that some bankers say was better for borrowers.

Before this scandal made headlines, few people outside of finance knew what Libor was. But according to the Center for Responsible Lending, half of the nation’s adjustable-rate home mortgages are based on it. Since 2002, more than 12 million A.R.M.’s, worth $3.5 trillion, have been indexed to Libor, according to the center.

That’s a lot of money resting on an interest rate that turns out to have been rigged.

But Libor didn’t always determine the rate on A.R.M.’s. Back in the 1990s, a much less volatile benchmark — the even more obscure-sounding 11th District Cost-of-Funds Index — was the norm for these loans. It represented the average rate paid to depositors by savings and loans in the Western region of the United States. The Federal Home Loan Bank of San Francisco, known as the 11th District and home to some of the largest mortgage lenders, compiled the rate every month. It makes sense to base adjustable-rate mortgages on lenders’ own costs of funds. That is because it links home loans’ rates to the rate paid on bank deposits. It also has the merit of being a rate based on reality — not, as in Libor’s case, on some bankers’ estimates.

John F. Maher, former chief executive of Great Western Bank, a large savings and loan that was later acquired, said that the old cost-of-funds index benefited borrowers.

“It is based on financial institutions’ average cost of funds, which moves relatively sluggishly compared to a marginal cost of funds, which is what Libor would be more associated with,” Mr. Maher said. “The sluggish nature of the index was better for borrowers; it didn’t have the risk for as much payment shock, because the payment changes moved so much more gradually.”

Because the cost-of-funds index tended to lag movements in prevailing interest rates, it didn’t respond as quickly as more volatile benchmarks did when interest rates declined. Conversely, though, it didn’t move up as fast, either. Even though some borrowers carped about this lag effect when rates fell, they ultimately reaped the benefits.

SO where does Wall Street come in? In the early to mid-1990s, as the home loan securitization machine got cranking, big brokerage firms looking to package and sell mortgage securities began pushing for a different index upon which A.R.M.’s could be based. The industry argued that it couldn’t hedge its mortgage holdings because there were no other securities based on the 11th District Cost-of-Funds Index. Libor, a more volatile index, appealed to traders as well.

“The volatile index was to respond to the needs of the secondary mortgage market, the guys who packaged the securities and the fellows who traded them,” Mr. Maher said.

By the late 1990s, the push for Libor became even more pronounced as brokerage firms sought overseas investors for their mortgage securities. Selling these instruments to foreign buyers would be far easier, the firms argued, if those instruments were tied to a well-known global benchmark.

“It was all about securitization, especially subprime loans,” said Guy D. Cecala, publisher of Inside Mortgage Finance, an industry authority. “You had Wall Street saying, ‘If we want to sell this overseas, we have to pick a more international-flavored index.’ Subprime lenders just started using it overnight, and then it started to spill out into any loan you wanted to securitize.”

As Libor became the dominant index for consumer loans in securitizations, the 11th District Cost-of-Funds Index fell into obscurity. Consolidation in the savings and loan industry also took its toll. In 1991, according to the Federal Home Loan Bank of San Francisco, the cost-of-funds index was based on costs incurred by 153 institutions. By 2001, only 49 institutions contributed to the index. As of last January, that number had dwindled to 17.

As it turned out, payment shock was the least of the problems faced by borrowers with Libor-based mortgages. Loans with unnaturally low teaser rates that expired relatively quickly were more responsible for borrower defaults and foreclosures.

It also appears that the rigging of the Libor by Barclays and others during the financial crisis may have benefited borrowers by pushing the rate lower than it otherwise would have been.

But it is interesting, if not surprising, that the dominant benchmark tied to A.R.M.’s was changed by Wall Street, for Wall Street. Now that we know Libor can and has been manipulated, it makes this shift all the more intriguing. After all, the 11th District Cost-of-Funds Index was a number published by the Federal Home Loan Bank of San Francisco, not a figure calculated by bankers.

TESTIFYING before the House Agriculture Committee last week about the Libor, Mr. Gensler, the head of the Commodity Futures Trading Commission, summed things up pretty well.

“If these key benchmarks are based on observable transactions, borrowers, lenders and derivatives users around the globe all benefit,” he said. If these key benchmarks are not based on observable transactions, I believe their integrity will continue to be subject to question.”

With trillions of dollars hanging in the balance, integrity could not be more important.


Back to July 2012 Archive

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