London Interbank Offered Rate On March 14, 2013, Freddie Mac filed a complaint

Assessment against Barclays Bank and more than a dozen other

financial institutions in the U.S. District Court for
On June 27, 2012, DOJ announced that Barclays
the Eastern District of Virginia. In its complaint, the
Bank admitted to manipulating the primary global
enterprise alleges that the “defendants collectively
benchmark for short-term interest rates—the
manipulated and suppressed [LIBOR], a benchmark
London Interbank Offered
rate indexed to trillions of
Rate (LIBOR). Within days,
dollars in interest-rate swaps
OIG staff began analyzing Freddie Mac alleges and loans that plays a funda-
how that manipulation may
mentally important role in
have affected the enterprises, banks’ manipulation financial systems throughout
specifically whether it may
the world” and that this
have increased losses that caused substantial manipulation “caused substan-
taxpayers ultimately absorbed
through their investment to losses tial losses to Freddie Mac.”
keep the enterprises solvent. In
November 2012, after weeks
of ongoing discussion with FHFA, OIG formally
sent the agency our preliminary estimate of potential The following minitutorial (see pages 17-18)
LIBOR-related enterprise losses and recommended describes LIBOR, its relation to the
that FHFA: enterprises, and how manipulating it can
affect their bottom lines.
• require the enterprises to conduct detailed analy-
ses of the potential financial losses due to LIBOR
manipulation;

• consider options for prompt legal action, if

warranted; and

• coordinate efforts and share information with

other federal and state agencies.3

The agency agreed to implement our

recommendations.

16 Federal Housing Finance Agency Office of Inspector General

 How LIBOR Affects the Enterprises

LIBOR is the average interest rate that financial institutions around the world, such as
Barclays Bank, estimate it would cost them to borrow money from other institutions. Each
day, a group of large banks are polled, the top and bottom four estimates are dropped, and
the average interest rate is published. Then, banks around the world use that interest rate to
benchmark their loan making and borrowing.

In total, LIBOR is involved in calculating payments for over $300 trillion.

For example, many mortgage lenders rely on LIBOR to determine the interest rates they charge
for adjustable-rate mortgages. Taking into account the borrower’s profile, a lender might add
2-3 percentage points to LIBOR.

LIBOR is also involved in more complicated financial products, such as floating-rate invest-
ments that do not pay a fixed rate (e.g., a savings account that pays 2% each year) but instead
fluctuate. For example, if LIBOR is at 1%, a bond may advertise itself as LIBOR + 1, which
means that it pays 2% interest that month and 3% the next month if LIBOR rises to 2%.

Enterprises’ Floating-Rate Investments

The enterprises purchase, guarantee, and own large volumes of fixed-rate assets because they
buy mortgages. Predominantly, these mortgages relate to 30-year fixed-rate loans, which opens
the enterprises to the interest rate risk associated with fluctuations in prevailing interest rates.

To balance that risk, the enterprises make floating-rate investments, primarily bonds and
interest rate swaps.

Floating-rate bonds: For example, on entering conservatorship, Freddie Mac held

approximately $299 billion in floating-rate bonds that pay prevailing rates of interest
according to agreed schedules.

Interest rate swaps: Since homeowners generally prefer stable payments, the enter-
prises’ mortgage portfolios have more fixed-rate loans than floating-rate ones (i.e.,
adjustable-rate mortgages). To offset risk, the enterprises trade some of their fixed-rate
interest revenue for other institutions’ floating-rate interest revenue, which leads to a
stable combined portfolio whether interest rates rise or fall.

In large part, LIBOR determines how much the enterprises receive from their hundreds of
billions of dollars of floating-rate investments. Each month or quarter, the interest rate pay-
ments are recalculated based on LIBOR’s current value, so a small change can have large
effects on the enterprises’ bottom lines.

Semiannual Report to the Congress • October 1, 2012–March 31, 2013 17

Lower LIBOR = Higher Losses

Barclays Bank admitted to systematically underestimating how much other banks would
charge to loan it money, on the basis that lenders charge higher interest rates for borrowers
that represent higher risk. This projected a false picture of the bank’s financial condition during
the recent financial crisis. That is, high-risk investment requires a high return. In this case,
Barclays Bank’s low LIBOR estimates projected the bank’s soundness by identifying it—at
least in its own opinion—as low risk. However, while the maneuver strengthened Barclays
Bank, it weakened investment earnings that depended on LIBOR.

Currently, several lawsuits are underway that will help determine how widespread the practice
was, but one way to gauge the effect of LIBOR manipulation on the enterprises’ investments
is by comparing its performance to another benchmark rate, the Federal Reserve’s eurodollar
deposit rate (Fed ED). Like LIBOR, this benchmark rate is determined by polling financial
institutions—in this case, a larger cross section of financial institutions—to measure short-
term borrowing costs. Historically, the two rates performed nearly identically; from 2000 to
mid-2007, for example, the two rates mirrored each other.

However, as Figure 9 (see below) demonstrates, in early 2007 as the financial crisis deep-
ened, LIBOR and Fed ED began to diverge. By the end of September 2008, LIBOR was 3%
lower than Fed ED. For the enterprises, that could have meant 3% less return on hundreds of
billions of dollars of investments if the LIBOR rate was manipulated.

Figure 9. LIBOR vs. Fed ED 2006-2010

7%

6%

5%

4%

3%

2%

1%

0%

January-06 January-07 January-08 January-09 January-10

1 Month Fed ED Deposit 1 Month LIBOR

18 Federal Housing Finance Agency Office of Inspector General