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The Wall Street multibillion-dollar scandal no one is talking about

March 23, 2012: 5:00 PM ET

The LIBOR trading scandal could turn out to be far worse for Wall Street than its mortgage troubles.

FORTUNE -- Much of the talk about bad behavior on Wall Street since the financial crisis has been about mortgages with a little bit of insider trading sprinkled in. And that makes sense. Everyone immediately understands what a mortgage is. And the housing bust that resulted from all those bad home loans affected us all. And Hollywood has taught us to ooh and ah over insider trading.

But there is another scandal that has come out of the financial crisis that at least to me makes the mortgage underwriting scandal look like small peanuts, and it has been heating up lately. Two weeks ago, the government disclosed that it is looking into bringing criminal cases against traders and banks that manipulated a key bank lending rate, called LIBOR. A source close to the case says the government's "may" will be dropped soon. Both Barclays and Deutsche Bank have disclosed that they have been the focus of investigations. Banks have suspended dozens of traders. Today, Credit Suisse announced that it was cooperating with regulators on the case. Traders at UBS reportedly are already working with the government on its investigation. Looking for instances in which Wall Streeters go to jail, unlike mortgages, this may be the one.

And yet because it is over a technical sounding bank lending rate, and has been developing for years, the scandal has mostly passed over the public without a real knowledge on what it's about. But to understand the real rot on Wall Street, and how widespread it is, you should.

Consider what went on here. Banks took a rate that they artificially set themselves, and then went out and convinced municipalities and pension funds and others to bet against them on the rate. LIBOR rates were supposed to be set by bank treasurers reflecting what it cost them to borrow from other banks. But reportedly a number of bank treasurers consulted traders when deciding what rate to report to the organization in London that collected and posted the rates. (LIBOR stands for the London InterBank Offered Rate) What's more, traders at a number of banks were given access to the systems that bank officials used to enter the rate so they could overwrite the rates with ones that would better suit them. When the rate went the way Wall Street traders programed it to do, the banks cashed in millions.

The LIBOR rate also affects what many of us pay on our adjustable mortgage, home equity loans, car loans and others. But that is a little bit of an aside. The real, clear damage is in the contracts that banks set up with municipalities and others to bet on their own manipulated rates. Baltimore was sold as much as $300 million in LIBOR contracts. The city is the lead plaintiff in the class action against the banks. The suits say the LIBOR market is as large as $90 trillion. Though some have put the market of things the rates affects as much as $350 trillion in loans and derivatives. The suit says on average over the period it was manipulated the banks artificially held the LIBOR rate down by 0.87%. Go with the smaller figure and by back of the envelope math, you get that the banks could have made as much as $750 billion on their scheme, but it probably wasn't that much since banks were probably asked to long and short on the rate.

The case also says something about the limits of morality on Wall Street. As the manipulation of LIBOR got worse, a number of Wall Street strategists pointed out that something was off here. One strategist Tim Bond at Barclays even went on Bloomberg television and stated quite clearly that he believed the rates were made up. What was he or his firm going to do about it? Nada. He said his bank's treasurer, who he identified as someone who took his role in reporting LIBOR seriously, at one point put his foot down and said he was going to report the bank's real LIBOR rate, which is to say higher than they had been reporting, indicating, you would assume accurately, that the bank was having some problems borrowing. Bond says all the bank got in return was bad press. So Barclay's wasn't going to do that again. Bond didn't return my phone calls for comment.

Another interesting note about the LIBOR case, especially in light of the Greg Smith public resignation from Goldman Sachs and all the scrutiny of that bank, is that this is one scandal Goldman appears not to be a part of. The firm is not named in the suits. There is more than one firm on Wall Street that treats its clients like Muppets.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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