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Mortgage Borrowers Suing Libor Banks For Making Their Rates Too Low Because Hey, Why Not?

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You may not share my tastes in this sort of thing but I'm going to go ahead and give American Banker a gold star for the headline "Libor-Rigging Set Interest Rates Too Low, Too High and So Low They Were Too High." The reference is to this Journal article about the mishegas of Libor lawsuits. Since every bank seems to have manipulated Libor, and in different directions at different times, you get to sort of take your pick about what you want to sue over. And so some borrowers are suing banks for setting Libor too low, some municipal swaps counterparties etc. are suing banks for setting Libor too high, and one cable-car driver is taking the second derivative:

Carl Payne, a 72-year-old former cable-car driver in San Francisco, alleged in a federal-court suit filed in December that manipulating interest rates lower inflated margins on adjustable-rate mortgages tied to U.S. dollar Libor. The law firm acting on Mr. Payne's proposed class action suit, Baron & Budd P.C., estimates that about a million mortgages were affected.

The interest rate on the mortgage for his condominium is based on the one-year rate plus a 2.25-percentage-point margin that is fixed over the life of the 30-year loan. Because the rate when he took out the mortgage was artificially low, Mr. Payne says, he was locked into a higher margin than he should have been.

This is obviously my favorite! I've been making this argument sinceJuly and I sort of assumed I was kidding, but no, Mr. Payne is right there with me:

The Journal article is about all the legal complexities involved in getting these lawsuits heard and go read it if you're interested - why wouldn't you be? - but here let's just ... I mean, we can discuss the substance of that claim, or just bask in its prettiness for a while, that's okay too. It's very pretty!1

So should he win? I guess it depends on whether he got "the market rate" for his adjustable rate mortgage, or whether he got "the market spread" for his ARM, plus Libor? If he got charged the "right" rate, while Libor was too low, then his math is exactly correct and he should sue. (I mean: get to keep suing.) If he got charged a market spread, then all that happened is that his mortgage was initially a bargain (for him), and then it went back up to being a market-rate mortgage once banks stopped manipulating Libor, but for a while he made out like a bandit and maybe they should sue him. (Not really.)

I think this question in turn depends on another question, which is: when you were writing Payne's loan, what did you think Libor was? Was it the risk-free rate, as people like me thought in 2007? Or was it just the cost at which banks borrowed unsecured, like BBA said it was?

Either way, if you're making a loan, you really ought to charge the borrower (1) the true risk-free rate, plus (2) some premium for the market cost of funding, equal to the difference between banks' borrowing cost and the risk-free rate, plus (3) the true risk premium for his loan. If you expect (2) - the cost of funding - to be mostly reflected in Libor, then you combine (1) and (2) into "Libor" and charge him a fair spread on top of that. That's in expectation; you'd charge him a fair credit spread even if right now Libor does not reflect bank borrowing costs. If you thought of Libor as the cost of bank funding, and you thought that it would mostly reflect that except perhaps in periods of crisis, then you probably charged Mr. Payne a fair spread.

On the other hand if you expected Libor to reflect a risk-free rate, either out of fudging or aesthetics, then you've got to charge for your costs of funding somehow. So you put that in spread. If later Libor stops being manipulated and starts reflecting bank funding costs, then you're effectively charging him twice for those costs - once in Libor, and once in your spread. If the expectations for Libor were that it would go on being manipulated forever, then Payne has a case against the banks. Which seems appropriate.

Banks Face Key Hurdle in Libor Fight [WSJ]
Libor-Rigging Set Interest Rates Too Low, Too High and So Low They Were Too High [AB]
Complaint: Payne et al. v. Bank of America, et al.

1.It's also scary for banks I guess? Is it? The theory behind it being scary is that Libor has been a bit of a tough sell as a megascandal just because it's hard to identify human beings who were hurt by it: Liborgate lowered interest rates, so it made your mortgage cheaper, so what's the problem? A compelling lawsuit claiming that Libor raised mortgage costs is bad PR. That said, "the banks screwed me by charging too low a rate that later went up to a higher rate when they stopped manipulating Libor" is a bit of a complex sell. Though I guess it can be reduced to the old reliable:

"I thought I could trust the big banks and that I wouldn't be in this situation at my age," Mr. Payne said in comments relayed by his lawyer. "Unfortunately, I was wrong."

At some point "I thought I could trust the big banks" will lose its rhetorical force, no?