FORTUNE -- It has been a year since Baltimore sued the big banks -- Bank of America (BAC), Barclays (BCS), Citibank (C), HSBC (HBC), J.P. Morgan (JPM), Lloyds (LYG), UBS (UBS), and WestLB -- the first of many lawsuits to claim that those institutions illegally manipulated the London interbank offer rate, or Libor. It was esoteric stuff until recently, when Libor became an international scandal that spilled beyond the business pages. Regulators now allege that for years several banks may have lied about the interest rates they paid to borrow money from one another. The falsely low rates affected just about everyone, since the interest on trillions of dollars in consumer and municipal loans is set against Libor.
One might think that low rates would help a borrower, just as they help a mortgage or credit card holder, but in this case the opposite is true. Baltimore is not a rich town. The triple punch of the credit crisis, housing crash, and recession has forced the city to choose. Fire departments or afterschool programs? Police or libraries? As the first municipality to seek reparations in response to this alleged scheme, Baltimore was my destination to see how the Libor scandal was playing out.
En route to City Hall, my train snakes through East Baltimore's boarded-up, notoriously decrepit row houses. A significant revitalization effort has transformed downtown, but about a quarter of the population still lives below the poverty line, and 87% of children in schools are eligible for food assistance. Unemployment hovers above the national average. The $60 million fiscal 2012 budget gap was closed with furloughs, firings, and cutbacks to recreational centers, library hours, and youth-employment programs.
I meet with city councilman Nick J. Mosby, who represents District 7. Just west of Baltimore's center, Mosby's district feels like the city's diverse, metaphorical heart. Blocks hit hardest by the mortgage mess sit next to areas inhabited by affluent professionals. White working-class neighborhoods are just around the corner from areas that nurtured jazz musicians Cab Calloway and Chick Webb. The district is home to Frederick Douglass High, one of the nation's oldest integrated schools. Thurgood Marshall is an alumnus. One of the country's oldest housing projects, the McCulloh Homes, is just outside the district lines.
Mosby wants me to see that his neighborhood "is a lot more than just The Wire," he says, referring to the HBO series about the drug trade in the city. We drive to Druid Hill park, past tree-lined avenues and grand limestone townhouses. "Everything can change in just a block," he says. We turn a corner and everything does: a quilt of abandoned houses, boarded windows, and gardens fighting to grow in empty lots. It's the middle of a workday, but old men perch on decrepit stoops. Young men lean against walls and stair railings and laugh. Gangs of little boys run up and down the street. They eye the councilman's black BMW. "Is it because a car this nice is unusual here?" I ask. Mosby laughs. "They see cars a lot nicer than this," he replies. "It's just they don't know this particular car."
To illustrate the way his constituents have been affected by budget cuts, Mosby tells me a story about a man in his district who couldn't find a job. "He still regularly volunteered at his local rec center because he believed that it kept him off the streets. Now it's closed. He has no place to work or volunteer, and there are kids who have no safe place to go. Could a few million dollars have kept that center open, and more? Yes."
Mosby is a 33-year-old native Baltimorean. He has been in office only eight months. He left a career in electrical engineering because, he says, he is inspired by politics. When I smirk, he gives me a sympathetic nod, like he feels a little sorry for my cynicism. Government can change the world for the better, he says, even if takes a long time. The city elected its first black mayor when Mosby was just a boy. Now a black woman, Mayor Stephanie Rawlings-Blake, is in charge. He recommends a book called Not in My Neighborhood, about how racism shaped the neighborhoods of Baltimore. He tells me that the book will help me understand the city better, and see how unchecked power can devastate a society for generations. Right now that force isn't Jim Crow. It's credit. "Finance, lending, bad mortgage practices -- it's all reshaping our country again," he says.
Mosby and I alight from his car at the Mondawmin Mall. Teen-centric clothing stores are mixed with brow art, wig, and nail shops. People inspect the jewelry display outside Milan Gold and Diamonds, and groups stroll down the halls. But look beyond the packs of window shoppers and you'll find empty stores. Mosby keeps his distance while I conduct my interviews, but he pounces the minute I finish. "What did they say? What do they think?"
The councilman and I are stopped by Manuel Ringgold, who is handing out fliers for his Christian hip-hop radio show. ("Gospel rap with meaning and purpose.") Neither Ringgold nor his friend Adrian Scott has heard about Libor. "That have anything to do with Wells Fargo?" Ringgold asks, referring to the discriminatory/predatory lending case Baltimore won that very morning. I launch into my explanation of the lawsuit, which is mostly cribbed from notes that I took during an interview with Peter Shapiro of Swap Financial Group. I have already delivered this spiel to a floor technician, an out-of-work garbageman, a librarian at Johns Hopkins University, and a woman at the Post Office. Over the next 36 hours I'll recite it to a man working at a mobile HIV/AIDS testing unit, a bartender, a man with the name CANDACE tattooed across his throat, and a woman on her way to church. (The floor technician was the most interested, the librarian the least, and the garbageman wanted me to help him file a discrimination suit against his former employer.) Everyone is willing to believe the banks are guilty, whether or not they understand the accusations.
After I tell Ringgold and Scott what Libor is -- which everyone seems to readily grasp -- I explain that Libor manipulation could have hurt municipalities like Baltimore, which financed used swaps.
Baltimore entered into two financial arrangements. The first was to sell a so-called floating-rate bond. Most bonds move up and down after an investor buys them, but floating-rate bonds maintain a steady value. In order to do that, they pay investors higher interest rates when the bond falls in worth, and lower rates when the bond rises. This calculation is made weekly, so the interest payment to an investor can change from week to week. In this case, the change in the interest rate is priced from an index of similar municipal bonds.
As the city sold those bonds, it wanted to find a way to make floating-rate debt more predictable. So Baltimore engaged in the second transaction. It entered into a swap agreement with the bank. Under the terms of the swap, the bank pays the city a floating interest rate that should, in theory, move in line with the rate paid to buyers of the city's bonds. It's akin to having the bank cover the interest payment on an adjustable-rate mortgage. Under this arrangement, Baltimore no longer had to worry about whether rates were going up or down, since the interest payments coming in from the bank roughly matched those going out to investors. The only cost it had to worry about was the flat, predictable cost of buying the swap.
But swaps are usually priced against Libor, not an index of bonds. So if Libor was artificially suppressed, the interest the bank paid to the city was reduced, and it was no longer enough to offset the interest payments the city was making to investors.
"Based on our best estimates, Baltimore would have lost about $6 million in the three-year period between 2008 and 2010," Shapiro explained, referring to the credit crisis. "And there are something like $200 billion in Libor-based muni swaps. If Libor was manipulated by 10 to 30 basis points, that's an aggregate total of about $1.2 billion that muni swap users could have been shortchanged."
Scott, 54, is impressed by the $1.2 billion number, but he seems convinced that the banks are guilty long before I reach the bottom line. "Sure the banks would lie to make themselves look better. That's the banksters' modus operandi, to be in it for themselves," he says. He is tall and lean, with a broad smile and salt-and-pepper hair. A native, he pronounces Baltimore "Balamore." He says, "I take it personally when someone attacks my hometown."
Scott works himself into a small frenzy, opining on the recent predatory lending case, the history of banks discriminating against black people, and high interest rates. But his outrage passes quickly. "I have a bank account. I have to," he says. "So in the end, they got me. And that is what it is." A fire alarm goes off, and shoppers saunter by as we talk about interest rates over the wailing sirens. "We don't pay attention to alarms here," Ringgold says.
The sun is setting over the Hampden neighborhood of Baltimore, just northeast of Mondawmin. While the majority of Baltimore is black (about 64% as of the last census), Hampden is mostly a white, blue-collar neighborhood that has gentrified. College-educated young professionals and artists in their 20s settled among the retired mill workers, bringing with them art galleries, boutiques, and yoga studios. Christian Sturgis and I sit at a local bar and talk about Libor, the city, and taxes. Sturgis, 40, is a Baltimorean who plays guitar in local punk and hard-core bands; he also owns an antiques shop on Roland Avenue. He's one of the few people I met who knows about the Libor lawsuit. He heard about it on the radio, between stories about Spain's debt and mortgages.
"If the city loses money because banks manipulated Libor, that means that I end up paying higher taxes to make up the shortfalls," Sturgis says, noting that property taxes and income taxes have soared in the past 14 years. "I'm glad we're trying to get money back from the banks, rather than putting the full burden of this on taxpayers," he says. (Agreeing that high taxes threaten growth, a spokesman from the mayor's office says that the city has implemented a plan to cut taxes by 9% over the next eight years.)
"Didn't we already bail them out?" Sturgis grins. "We gave them money, and now it seems like they found a way to take more. It's really hard to not be a conspiracy theorist. How many times can a group of people at the same banks try to game the system in different ways before you wonder what's going on?"
I tell him that people on Wall Street don't see it that way, that it's viewed more as a series of unfortunate events rather than an ecosystem that fosters greed and avarice in hidden corners. Sturgis smiles again. "I guess it looks different from the outside."
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