A $360 trillion confidence trick

Riddle me this: what’s the most important set of numbers in the entire world? The climate change models that say how much time is left until carbon dioxide levels pass the point of no return? Or the numbers that comprise the launch codes for our nuclear warheads?

Either might qualify but some experts would instead point to something else: Libor inputs. Libor’s the interest rate that underlies $360 trillion of financial contracts worldwide. Interest rate swaps and corporate loans, but also mortgages, student loans, credit cards and more. What’s $360 trillion dollars? That’s the economic size of 24 United States of Americas.

Or 360 times the amount of money depicted in the following graphic. That’s a person standing there in the lower left, by the way.

(Hat tip to Pagetutor for the image.)

So, you could say that Libor is kind of important. Donald MacKenzie says that it’s so important that those responsible for it even have “dedicated phone lines laid into their homes so they can still work if a terrorist attack or other incident stops them reaching the office”.

But it looks like the only threats to Libor these days are from the banks that created it.

Libor was created at the same time that British banks were deregulated by Margaret Thatcher’s Big Bang. At the time they also happened to be introducing new products for their institutional clients, like contracts that would allow them to hedge interest rate changes. These could be hugely profitable but their cash flows needed to be fixed to an objective unit of measurement that was consistent, trusted, not too volatile, but also dynamic enough to reflect changes in the risk environment. In 1986 the British Bankers’ Association, a trade group that represents both British and foreign banks, became the guardian of just such a universal benchmark. Libor, or the London Interbank Offered Rate, was born.

Back then few would have imagined how much more massive, complex and interlinked the global financial markets would become. Natch Libor. You, yourself, may have one or two monthly payments directly tied to it. Or consider the $20 billion loan given to AIG by the Federal Reserve in 2008. What interest rate did AIG pay? Libor + 1 percent. Most large multinational corporations either pay or receive cash flows that are directly tied to Libor, and many other kinds of companies and institutions besides.

Maybe if we had all known how important Libor would become then it wouldn’t have been designed in such a pitiful and ridiculous way.

Here’s how Libor’s calculated. Every weekday morning someone working in the treasury at one of the designated Libor banks (a seldom-changed list of 7 to 18 major institutions) gets a call and is asked something like this: “If you guys wanted to borrow some money this morning from another bank, what interest rate do you think you’d have to pay?” Note: this is not an unkind translation. The actual phrasing referred to by the British Bankers’ Association is almost as succinct.

After all the banks on the list have been called (by Thomson Reuters working on the BBA’s behalf), the compilers line the figures up and look at them. Now, consider carefully what happens next. If any of the figures diverge beyond accepted tolerances, then Thomson Reuters will call to verify that there is no error. The following clarification is copied directly from BBA’s Libor website:

A call to a contributor to check a rate is in no way an accusation of inaccuracy or manipulation, it is a request for confirmation and as such does not in any way stigmatise that contributor.

Quite.

After ensuring that there are no (ahem) errors, Thomson Reuters systematically removes several of the highest and the lowest and makes an average of the ones remaining. That figure becomes that day’s Libor rate for a given currency and a given maturity (12 months or less). And that’s all there is to it. It then becomes the ticket for trillions of dollars in several major currencies to fly in cyberspace to destinations all over the world. The only problem is that it’s now looking more and more like Libor’s lackadaisical process has been corrupted. And as Yves Smith might ask, “Is this a bug or a feature?”

The suspicions of the U.S. dollar Libor rate came out of the closet around 4 years ago. While markets were clearly starting to fear that some banks would not survive, the Libor panel banks continued to report that, in their judgement, they would still be able to borrow money from other banks at implausibly low rates. They were like a middle-aged woman who still insists that she can fit into her wedding dress.

Also even without any prompting each bank’s treasurer has incentive to embroider the truth because each panel bank’s Libor submission is published alongside of the final rate, itself. Banks whose solvency is in question will of course want to avoid raising any further suspicions about their financial health. So they may have sought to give the impression that it was easier for them to borrow than it actually was at the time. And by the way, everyone knew that this was going on.

An Austrian investment manager has filed a lawsuit against some of the panel banks and claims that the Bank of England’s monetary policy committee was tipped as early as November 2007. This was also reported in the Wall Street Journal. The Bank for International Settlements, (aka the central banks’ bank), issued a report in March 2008 that looked at the question and concluded that, while there may have been strategic reasons for banks to manipulate Libor, there was no evidence that they had actually done so. However in April a Citigroup strategist named Scott Peng wrote a report that called Libor’s credibility into question. Reportedly Peng stated that Libor “at times no longer represents the level at which banks extend loans to others.” (Rumors are that Peng’s resignation the next year was due to the trouble caused by his report. Unconfirmed rumors say that BBA had asked Citigroup to withdraw Peng’s report when it was published.)

On April 16, 2008 the Wall Street Journal wrote about the increasing suspicions. That same day the British Bankers’ Association announced that it was speeding up its own integrity-check of the Libor process. Some read this as a not-so-subtle hint for the fibbing banks to get their minds right. The very next day the Libor panel banks reported markedly higher rates.

 The Wall Street Journal followed up its own investigation the next month with an analysis that compared the reported Libor rates with other measures of perceived credit risk. It also declared that its study “cast doubt” on the rate. In the same week during an interview with Bloomberg Television Barclays strategist Tim Bond made a bold admission:

The rates the banks were posting to the BBA became a little bit divorced from reality. We had one week in September where our treasurer, who takes his responsibilities pretty seriously, said: `right, I’ve had enough of this, I’m going to quote the right rates.’ All we got for our pains was a series of media articles saying that we were having difficulty financing.

Finally, the British Bankers’ Association issued its own report in June of that year, promising “strengthened governance” but essentially saying that nothing was wrong. Meanwhile no peep was heard from any regulator anywhere. None would be until more than two years later.

And then suddenly last March we got word that the regulators had woken up. In its annual report UBS disclosed that it had received subpoenas from the SEC, CFTC, Department of Justice and also the Japanese regulator regarding its -Ibor submissions. The UK’s regulator has also joined in and now Barclays, Bank of America, RBS and Citigroup as well as other banks are thought to be under, or close to being under, investigation. The lawsuits have started rolling as well, with investment manager Charles Schwab being just one of the parties filing suit.

Did the banks collude to lowball Libor and disguise their troubles in the crisis? And did the regulators knowingly look the other way? If these were the only questions, we’d have already have plenty to chew on. But, of course, there’s more.

Suddenly there have been reports this month of banks firing or disciplining several traders and employees for allegedly tampering with Libor. And not necessarily for the good of the team, but rather as part of an intentional strategy for banks and their traders to increase their profit from derivatives linked to Libor, Euribor and Tibor. Hedge funds are also under suspicion, as are interdealer brokers like Icap and Tullet Prebon that may have served as information conduits. One senior industry figure told the Financial Times that “this is just another example of the slow drip of sleaze across the industry. How much more can it take?”

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• See also: Banks to face the Rico Act for robosigning credit cards?
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Tags: Bank of England, Barclays, BBA, Big Bang, British Bankers' Association, Charles Schwab, Citi, Euribor, Libor, Scott Peng, Thomson Reuters, Tibor, Tim Bond, UBS

Category: Banking