So, what is Libor and how does it work? Libor is supposed to be the average rate at which the world’s biggest banks can borrow from one another. The British Bankers Association, a group of more than 250 banks located in 50 countries, sets Libor.  The BBA sets rates for 15 different loan maturities in 10 different currencies.  There are ten Libor panels, one per currency, and the number of banks on the panels varies (there are 18 banks on the panel for the dollar). The panels do not use actual market rates to estimate Libor — rather, they estimate the interest rate that they think they would have to pay were they to borrow money from other banks on that day. In other words, they use hypothetical rates — they make them up. That, of course, is a recipe for rate manipulation.

But wait: there’s more.   In calculating the Libor rate for a currency, high and low rate estimates are discarded before averaging the rest.  In the case of the dollar, the four highest and four lowest rate estimates from the 18 banks are discarded, and then the remaining 10 are averaged. The other panels work similarly. The high and low rates are discarded to prevent one or two banks alone from manipulating the rates. What this says about the current Libor scandal is clear: they were all in on it. The rates could not be manipulated without the involvement of many of the big banks.  It is open and shut that there was gross collusion to rig the Libor rates. This is a scandal in its own right: once understood, it exposes the financial industry’s claims that it can and should self-regulate, and it exposes the state’s (certainly in Britain and the U.S.) that it is tightly monitoring the banks and running the show in the public’s interest.

Now, of course the big banks used their rate rigging to their benefit. They rigged Libor up; more frequently they rigged Libor down. The International Swaps and Derivatives Association alone reports that it has written $350 trillion worth of financial contracts tied directly or indirectly to Libor (compare this with “only” $10 trillion in total credit card and mortgage debt, and “only” about $60 trillion in global gross product). It doesn’t take a quant to recognize that even a tiny rigging of interest rates can lead to tens or even hundreds of billions of dollars of cumulative gains.

One consequences of Libor interest rate rigging has been to exacerbate the immense harm to local governments, school districts, community colleges, universities, hospitals and others caused by “interest rate swaps“.  Protests against interest rate swaps by municipalities, schools, and non-profits around the country have been growing over the past year, but like Libor itself, the way interest rate swaps actually work is rarely explained in the media and hence is not popularly understood.