"Taxpayers are paying billions of dollars for a swindle pulled off by the world’s biggest banks, using a form of derivative called interest-rate swaps." "It is not just that local governments, universities and pension funds made a bad bet on these swaps. The game itself was rigged." -- Ellen Brown, candidate for California State Treasurer

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The Global Banking Game Is Rigged, and the FDIC Is Suing

Posted on April 13, 2014 by Ellen Brown

Taxpayers are paying billions of dollars for a swindle pulled off by the world’s biggest banks, using a form of derivative called interest-rate swaps; and the Federal Deposit Insurance Corporation has now joined a chorus of litigants suing over it. According to an SEIU report:

Derivatives . . . have turned into a windfall for banks and a nightmare for taxpayers. . . . While banks are still collecting fixed rates of 3 to 6 percent, they are now regularly paying public entities as little as a tenth of one percent on the outstanding bonds, with rates expected to remain low in the future. Over the life of the deals, banks are now projected to collect billions more than they pay state and local governments – an outcome which amounts to a second bailout for banks, this one paid directly out of state and local budgets.

It is not just that local governments, universities and pension funds made a bad bet on these swaps. The game itself was rigged, as explained below. The FDIC is now suing in civil court for damages and punitive damages, a lead that other injured local governments and agencies would be well-advised to follow. But they need to hurry, because time on the statute of limitations is running out.

The Largest Cartel in World History

On March 14, 2014, the FDIC filed suit for LIBOR-rigging against sixteen of the world’s largest banks – including the three largest US banks (JPMorgan Chase, Bank of America, and Citigroup), the three largest UK banks, the largest German bank, the largest Japanese bank, and several of the largest Swiss banks. Bill Black, professor of law and economics and a former bank fraud investigator, calls them “the largest cartel in world history, by at least three and probably four orders of magnitude.”

LIBOR (the London Interbank Offering Rate) is the benchmark rate by which banks themselves can borrow. It is a crucial rate involved in hundreds of trillions of dollars in derivative trades, and it is set by these sixteen megabanks privately and in secret.

Interest rate swaps are now a $426 trillion business. That’s trillion with a “t” – about seven times the gross domestic product of all the countries in the world combined. According to the Office of the Comptroller of the Currency, in 2012 US banks held $183.7 trillion in interest-rate contracts, with only four firms representing 93% of total derivative holdings; and three of the four were JPMorgan Chase, Citigroup, and Bank of America, the US banks being sued by the FDIC over manipulation of LIBOR.

Lawsuits over LIBOR-rigging have been in the works for years, and regulators have scored some very impressive regulatory settlements. But so far, civil actions for damages have been unproductive for the plaintiffs. The FDIC is therefore pursuing another tack.

But before getting into all that, we need to look at how interest-rate swaps work. It has been argued that the counterparties stung by these swaps got what they bargained for – a fixed interest rate. But that is not actually what they got. The game was rigged from the start.

The Sting

Interest-rate swaps are sold to parties who have taken out loans at variable interest rates, as insurance against rising rates. The most common swap is one where counterparty A (a university, municipal government, etc.) pays a fixed rate to counterparty B (the bank), while receiving from B a floating rate indexed to a reference rate such as LIBOR. If interest rates go up, the municipality gets paid more on the swap contract, offsetting its rising borrowing costs. If interest rates go down, the municipality owes money to the bank on the swap, but that extra charge is offset by the falling interest rate on its variable rate loan. The result is to fix borrowing costs at the lower variable rate.

At least, that is how it’s supposed to work. The catch is that the swap is a separate financial agreement – essentially an ongoing bet on interest rates. The borrower owes both the interest onits variable rate loan and what it must pay out on this separate swap deal. And the benchmarks for the two rates don’t necessarily track each other. As explained by Stephen Gandel on CNN Money:

The rates on the debt were based on something called the Sifma municipal bond index, which is named after the industry group that maintains the index and tracks muni bonds. And that’s what municipalities should have bought swaps based on.

Instead, Wall Street sold municipalities Libor swaps, which were easier to trade and [were] quickly becoming a gravy train for the banks.

Historically, Sifma and LIBOR moved together. But that was before the greatest-ever global banking cartel got into the game of manipulating LIBOR. Gandel writes:

In 2008 and 2009, Libor rates, in general, fell much faster than the Sifma rate. At times, the rates even went in different directions. During the height of the financial crisis, Sifma rates spiked. Libor rates, though, continued to drop. The result was that the cost of the swaps that municipalities had taken out jumped in price at the same time that their borrowing costs went up, which was exactly the opposite of how the swaps were supposed to work.

The two rates had decoupled, and it was chiefly due to manipulation. As noted in the SEUI report:

[T]here is . . . mounting evidence that it is no accident that these deals have gone so badly, so quickly for state and local governments. Ongoing investigations by the U.S. Department of Justice and the California, Florida, and Connecticut Attorneys General implicate nearly every major bank in a nationwide conspiracy to rig bids and drive up the fixed rates state and local governments pay on their derivative contracts.

Changing the Focus to Fraud

Suits to recover damages for collusion, antitrust violations and racketeering (RICO), however, have so far failed. In March 2013, SDNY Judge Naomi Reece Buchwald dismissed antitrust and RICO claims brought by investors and traders in actions consolidated in her court, on the ground that the plaintiffs lacked standing to bring the claims. She held that the rate-setting banks’ actions did not affect competition, because those banks were not in competition with one another with respect to LIBOR rate-setting; and that “the alleged collusion occurred in an arena in which defendants never did and never were intended to compete.”

Okay, the defendants weren’t competing with each other. They were colluding with each other, in order to unfairly compete with the rest of the financial world – local banks, credit unions, and the state and local governments they lured into being counterparties to their rigged swaps. The SDNY ruling is on appeal to the Second Circuit.

In the meantime, the FDIC is taking another approach. Its 24-count complaint does include antitrust claims, but the emphasis is on damages for fraud and conspiring to keep the LIBOR rate low to enrich the banks. The FDIC is not the first to bring such claims, but its massive suit adds considerable weight to the approach.

Why would keeping interest rates low enrich the rate-setting banks? Don’t they make more money if interest rates are high?

The answer is no. Unlike most banks, they make most of their money not from ordinary commercial loans but from interest rate swaps. The FDIC suit seeks to recover losses caused to 38 US banking institutions that did make their profits from ordinary business and consumer loans – banks that failed during the financial crisis and were taken over by the FDIC. They include Washington Mutual, the largest bank failure in US history. Since the FDIC had to cover the deposits of these failed banks, it clearly has standing to recover damages, and maybe punitive damages, if intentional fraud is proved.

The Key Role of the Federal Reserve

The rate-rigging banks have been caught red-handed, but the greater manipulation of interest rates was done by the Federal Reserve itself. The Fed aggressively drove down interest rates to save the big banks and spur economic recovery after the financial collapse. In the fall of 2008, it dropped the prime rate (the rate at which banks borrow from each other) nearly to zero.

This gross manipulation of interest rates was a giant windfall for the major derivative banks. Indeed, the Fed has been called a tool of the global banking cartel. It is composed of 12 branches, all of which are 100% owned by the private banks in their districts; and the Federal Reserve Bank of New York has always been the most important by far of these regional Fed banks. New York, of course is where Wall Street is located.

LIBOR is set in London; but as Simon Johnson observed in a New York Times article titled The Federal Reserve and the LIBOR Scandal, the Fed has jurisdiction whenever the “safety and soundness” of the US financial system is at stake. The scandal, he writes, “involves egregious, flagrant criminal conduct, with traders caught red-handed in e-mails and on tape.” He concludes:

This could even become a “tobacco moment,” in which an industry is forced to acknowledge its practices have been harmful – and enters into a long-term agreement that changes those practices and provides continuing financial compensation.

Bill Black concurs, stating, “Our system is completely rotten. All of the largest banks are involved—eagerly engaged in this fraud for years, covering it up.” The system needs a complete overhaul.

In the meantime, if the FDIC can bring a civil action for breach of contract and fraud, so can state and local governments, universities, and pension funds. The possibilities this opens up for California (where I’m currently running for State Treasurer) are huge. Fraud is grounds for rescission (terminating the contract) without paying penalties, potentially saving taxpayers enormous sums in fees for swap deals that are crippling cities, universities and other public entities across the state. Fraud is also grounds for punitive damages, something an outraged jury might be inclined to impose. My next post will explore the possibilities for California in more detail. Stay tuned.

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Ellen Brown is an attorney, founder of the Public Banking Institute, and a candidate for California State Treasurer running on a state bank platform. She is the author of twelve books, including the best-selling Web of Debt and her latest book, The Public Bank Solution, which explores successful public banking models historically and globally.

Robert Reich's Blog

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The Remarkable Political Stupidity of the Street

Friday, December 9, 2011

Wall Street is its own worst enemy. It should have welcomed new financial regulation as a means of restoring public trust. Instead, it’s busily shredding new regulations and making the public more distrustful than ever.

The Street’s biggest lobbying groups have just filed a lawsuit against the Commodities Futures Trading Commission, seeking to overturn its new rule limiting speculative trading.

For years Wall Street has speculated like mad in futures markets – food, oil, other commodities – causing prices to fluctuate wildly. The Street makes bundles from these gyrations, but they have raised costs for consumers.

In other words, a small portion of what you and I pay for food and energy has been going into the pockets of Wall Street. It’s just another hidden redistribution from the middle class and poor to the rich.

The new Dodd-Frank law authorizes the Commodity Futures Trading Commission to limit such speculative trading. The commission considered 15,000 comments, largely from the Street. It did numerous economic and policy analyses, carefully weighing the benefits to the public of the new regulation against its costs to the Street. It even agreed to delay enforcement of the new rule for at least a year.

But this wasn’t enough for the Street. The new regulation would still put a crimp in Wall Street’s profits.

So the Street is going to court. What’s its argument? The commission’s cost-benefit analysis wasn’t adequate.

At first blush it’s a clever ploy. There’s no clear legal standard for an “adequate” weighing of costs and benefits of financial regulations, since both are so difficult to measure. And putting the question into the laps of federal judges gives the Street a huge tactical advantage because the Street has almost an infinite amount of money to hire so-called “experts” (some academics are not exactly prostitutes but they have their price) who will use elaborate methodologies to show benefits have been exaggerated and costs underestimated.

It’s not the first time the Street has used this ploy. Last year, when the Securities and Exchange Commission tried to implement a Dodd-Frank policy making it easier for shareholders to nominate company directors, Wall Street sued the SEC. It alleged the commission’s cost-benefit analysis for the new rule was inadequate.

Last July, a federal appeals court – inundated by Wall Street lawyers and hired-gun “experts” – agreed with the Street. So much for shareholders nominating company directors.

Obviously, government should weigh the costs against the benefits of anything it does. But when it comes to the regulation of Wall Street, one overriding cost doesn’t make it into any individual weighing: The public’s mounting distrust of the entire economic system, generated by the Street’s repeated abuse of the public’s trust.

Wall Street’s shenanigans have convinced a large portion of America that the economic game is rigged.

Yet capitalism depends on trust. Without trust, people avoid even sensible economic risks. They also begin trading in gray markets and black markets. They think that if the big guys cheat in big ways, they might as well begin cheating in small ways. And when they think the game is rigged, they’re easy prey for political demagogues with fast tongues and dumb ideas.

Tally up these costs and it’s a whopper.

Wall Street has blanketed America in a miasma of cynicism. Most Americans assume the reason the Street got its taxpayer-funded bailout without strings in the first place was because of its political clout. That must be why the banks didn’t have to renegotiate the mortgages of Americans – many of whom, because of the economic collapse brought on by the Street’s excesses, are still under water. Some are drowning.

That must be why taxpayers didn’t get equity stakes in the banks we bailed out – as Warren Buffet got when he bailed out Goldman Sachs. That means when the banks became profitable gain we didn’t get any of the upside gains; we just padded the Street’s downside risks.

The Street’s political clout must be why most top Wall Street executives who were bailed out by taxpayers still have their jobs, have still avoided prosecution, are still making vast fortunes – while tens of millions of average Americans continue to lose their jobs, their wages, their medical coverage, or their homes.

And why the Dodd-Frank bill was filled with loopholes big enough for Wall Street executives and traders to drive their ferrari’s through.

The cost of such cynicism has leeched deep into America, causing so much suspicion and anger that our politics has become a cauldron of rage. It’s found expression in Tea Partiers and Occupiers, and millions of others who think the people at the top have sold us out.

Every week, it seems, we learn something new about how Wall Street has screwed us. Last week we heard from Bloomberg News (that had to go to court for the information) that in 2009 the Street’s six largest banks borrowed almost half a trillion dollars from the Fed at nearly zero cost – but never disclosed it.

In early 2009, after Citigroup tapped the Fed for almost $100 billion, the bank’s CEO, Vikram Pandit, had the temerity to call Citi’s first quarter the “best since 2007.” Is there another word for fraud?

Finally, everyone knows the biggest banks are too big to fail — and yet, despite this, Congress won’t put a cap on the size of the banks. The assets of the four biggest – J.P. Morgan Chase, Bank of America, Citigroup, and Wells Fargo – now equal 62 percent of total commercial bank assets. That’s up from 54 percent five years ago. Throw in Goldman Sachs and Morgan Stanley, and these six leviathans preside over the American economy like Roman emperors.

Speaking of Rome, if Italy or Greece defaults and Europe’s major banks can’t make payments on their debts to Wall Street, another bailout will surely be required. And the politics won’t be pretty.

There you have it. A federal court will now weigh costs and benefits of a modest rule designed to limit speculative trading in food and energy.

But in coming months and years, the American public will weigh the social costs and social benefits of Wall Street itself. And it wouldn’t surprise me if they decide the costs of the Street as it is far outweigh the benefits.

The result will be caps on the size of banks. Some will be broken up. Glass-Steagall will be resurrected. Some Wall Street bigwigs may even see in the insides of jails.

If so, the Street has only itself to blame.

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Robert Reich is Chancellor's Professor of Public Policy at the University of California at Berkeley. He has served in three national administrations, most recently as secretary of labor under President Bill Clinton. He has written thirteen books, including The Work of Nations, Locked in the Cabinet, Supercapitalism, and his most recent book, Aftershock. His "Marketplace" commentaries can be found on publicradio.com and iTunes. He is also Common Cause's board chairman.

Federal Judge Pimp-Slaps the SEC Over Citigroup Settlement

POSTED: November 29, 10:10 AM ET

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Chris Goodney/Bloomberg via Getty Images/Andrew

Harrer/Bloomberg via Getty Images

Greetings, folks. Hope everyone had a good Thanksgiving…

Just a quick update on a big piece of news that came through yesterday. In one of the more severe judicial ass-whippings you’ll ever see, federal Judge Jed Rakoff rejected a slap-on-the-wrist fraud settlement the SEC had cooked up for Citigroup.

I wrote about this story a few weeks back when Rakoff sent signals that he was unhappy with the SEC’s dirty deal with Citi, but yesterday he took this story several steps further.

Rakoff’s 15-page final ruling read like a political document, serving not just as a rejection of this one deal but as a broad and unequivocal indictment of the regulatory system as a whole. He particularly targeted the SEC’s longstanding practice of greenlighting relatively minor fines and financial settlements alongside de facto waivers of civil liability for the guilty – banks commit fraud and pay small fines, but in the end the SEC allows them to walk away without admitting to criminal wrongdoing.

This practice is a legal absurdity for several reasons. By accepting hundred-million-dollar fines without a full public venting of the facts, the SEC is leveling seemingly significant punishments without telling the public what the defendant is being punished for. This has essentially created a parallel or secret criminal justice system, in which both crime and punishment are adjudicated behind closed doors.

This system allows for ugly consequences in both directions. Imagine if normal criminal defendants were treated this way. Say a prosecutor and street criminal combe into a judge’s chamber and explain they’ve cooked up a deal, that the criminal doesn’t have to admit to anything or plead to any crime, but has to spend 18 months in house arrest nonetheless.

What sane judge would sign off on a deal like that without knowing exactly what the facts are? Did the criminal shoot up a nightclub and paralyze someone, or did he just sell a dimebag on the street? Is 18 months a tough sentence or a slap on the wrist? And how is it legally possible for someone to deserve an 18-month sentence without being guilty of anything?

Such deals are logical and legal absurdities, but judges have been signing off on settlements like this with Wall Street defendants for years.

Judge Rakoff blew a big hole in that practice yesterday. His ruling says secret justice is not justice, and that the government cannot hand out punishments without telling the public what the punishments are for. He wrote:

Finally, in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world, propaganda reigns, and truth is confined to secretive, fearful whispers. Even in our nation, apologists for suppressing or obscuring the truth may always be found. But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency's contrivances.

Notice the reference to how things are “in much of the world,” a subtle hint that the idea behind this ruling is to prevent a slide into third-world-style justice. There are many such loaded passages in Rakoff’s ruling. Another one comes up around the issue of the “public interest.”

This issue of whether or not the SEC must consider the public interest in granting these cozy settlements gets to the heart of the Occupy Movement's central complaint, that there are two different sets of rules for two different Americas. The SEC in this case incredibly argued – out loud, on paper – that it could make regulatory decisions without considering the public interest. In particular, it argued that it didn’t need to consider the public interest when granting “injunctive relief,” i.e. an injunction barring future behaviors, as opposed to the stiffer and more immediate punishment of fines or criminal charges.

The SEC argued to Judge Rakoff that "the public interest ... is not part of [the] applicable standard of judicial review."

Translating: “When we decide to let thieving megabank off with just a promise to never do it again, we don’t have to consider whether or not this is in the public interest.”

If you stand back and really think about what this argument means, it’ll make your head spin. What the SEC is saying here is that according to the incestuous values of the small community of high-priced revolving-door lawyers who both head the SEC enforcement office and run the defense teams of banks like Citi, a $95 million fine with no admission of wrongdoing for a $700 million fraud is, in fact, “fair” and “reasonable.”

The settlement only becomes problematic, the SEC implies, if you ask them to square their judgment with “the public interest.”

The SEC, in other words, is admitting that they have a standard for “reasonableness” and “fairness” that somehow does not coincide with the public interest. This surreal formulation translates as, “We’re doing the right thing – we’re just not doing it for the public.”

Rakoff’s response to this lunacy:

A large part of what the S.E.C. requests, in this and most other such consent judgments, is injunctive relief... The Supreme Court has repeatedly made clear, however, that a court cannot grant the extraordinary remedy of injunctive relief without considering the public interest.

The Rakoff ruling shines a light on the way these crappy settlements have evolved into a kind of cheap payoff system, in which crimes may be committed over and over again, and the SEC’s only role is to take a bribe each time the offenders slip up and get caught.

If you never have to worry about serious punishments, or court findings of criminal guilt (which would leave you exposed to crippling lawsuits), then there’s simply no incentive to stop committing fraud. These SEC settlements simply become part of the cost of doing business, as Rakoff notes:

As for common experience, a consent judgment that does not involve any admissions and that results in only very modest penalties is just as frequently viewed, particularly in the business community, as a cost of doing business imposed by having to maintain a working relationship with a regulatory agency, rather than as any indication of where the real truth lies. This, indeed, is Citigroup's position in this very case.

That line, “a cost of doing business imposed by having to maintain a working relationship with a regulatory agency,” is one of the more brutally damning things you’ll ever see a judge write. Rakoff is saying that these fines are payoffs to keep the SEC off the banks’ backs. They’re like the pad that numbers-runners or drug dealers pay to urban precinct-houses every month to keep cops from making real arrests. That's what he means when he refers to "maintaning a working relationship." It's heavy stuff.

On the other hand, both the SEC and Citigroup insist that this secretive payoff system is defensible and must continue. They clearly believe, sincerely, that none of this stuff is really the public’s business.

This is an extraordinarily condescending attitude and shows exactly how little they think of the public at large. One wonders if decisions like Rakoff’s will at least help to wake the government up.

Plus: Here’s a clip of me talking about the ruling last night on Countdown with Keith Olbermann.