Libor: here’s what you need to know

If you hadn’t heard of the Libor scandal until last week, then you’re probably gobsmacked right now. Regular readers of the Finance Addict knew about this months ago. (Just sayin’.) Mind you, it’s only taken almost 5 whole years from the time this story was first reported by the Financial Times to reach the tipping point that it has now. But now it’s moving. Oh boy, is it moving. Here’s what you should know about Libor.

1. Libor sits at the center of everything.
When Matt Taibbi calls Libor ”the sun at the center of the financial universe” he’s not kidding. Use of the benchmark floating interest rate is widespread and each new estimate seems bigger than the last. The one from the Commodities Futures Trading Commission seems like a good place to start: the Wall Street Journal reports the CFTC’s estimate as $800 trillion. This $800 trillion includes many mortgages in America, Britain, Canada and Australia. Plus credit cards, car and student loans. Additionally, most of the U.S. dollar-denominated deposits at banks outside of the U.S are tied to the Libor interest rate. This means that any multi-national institution — be it Wal-Mart, BMW or Exxon — with bank accounts outside of U.S. are likely to be affected by it. As if that weren’t enough, Libor also governs the derivatives contracts struck between banks and corporations, governments, pension funds and insurance companies.

2. Banks had 2 motives for manipulating Libor.
Since Libor is tied to so many financial products, it directly affected the profits that banks could make on their loan customers and from their trading with fellow banks. Barclays has admitted to manipulating Libor before the financial crisis struck in order to profit from it. But Libor is also a measure of financial strength: it’s like a credit score — the less creditworthy a bank is the more interest it will have to pay to borrow and thus the higher its Libor rate should be. During the financial crisis banks were scared of being seen as the next Lehman. So they lied about Libor to make it look as if they could borrow money for much less than they actually could.

3. Some say Libor manipulation has been going on for decades.
From the Economist:

Fifteen years ago the word was that LIBOR was being rigged,” says one industry veteran closely involved in the LIBOR process. “It was one of those well kept secrets, but the regulator was asleep, the Bank of England didn’t care and…[the banks participating were] happy with the reference prices.” Says another: “Going back to the late 1980s, when I was a trader, you saw some pretty odd fixings…With traders, if you don’t actually nail it down, they’ll steal it.”

4. It may constitute a criminal cartel.
Companies want to sell their products for as much money as possible (duh.) What’s one way to keep prices high? Get together with all the other companies in the industry and agree to do so. The only thing that keeps this from happening are governments’ antitrust laws. 

The British regulator’s complaint against Barclays makes clear that, even before the financial crisis hit, other Libor-submitting banks asked Barclays to cheat its own Libor and Libor-equivalent submissions.

[O]n 6 September 2006, an external trader at another bank (Panel Bank 1) contributing EURIBOR submissions sent an instant message to Trader E at Barclays requesting a low one month submission: “I seriously need your help
tomorrow on the 1mth fix”. The next day, Trader E passed on the request to Barclays’ Submitters, blind copying in the external trader.

Traders at Barclays also made their own requests at other submitting banks. Check out this post from David Merkel of Aleph Blog, in which he does some investigative work that shows which banks might have been working together.

5. The Bank of England may have encouraged Libor manipulation to comfort senior British politicians afraid of a British “Lehman Bros.”
This scandal has claimed the head of Bob Diamond, the former CEO of Barclays. At one point before resigning he seemed ready to fight the allegations: CNBC said he was “threatening to reveal potentially embarrassing details about Barclays’ dealings with regulators.”  Last week he released an e-mail that he’d sent to his deputies in October 2008, in which he described a phone call with Paul Tucker, deputy governor of the Bank of England.

“Mr Tucker stated the levels of calls he was receiving from Whitehall [the center of British government] were ‘senior’ and that while he was certain wed did not need advice, that it did not always need to be the case that we appeared as high as we have recently.”

Wink, wink, nod, nod. Tucker will be grilled by UK lawmakers on Monday.

See also the New York Times’ discussion with David Blanchflower, an economist who often joined meetings at the Bank of England:

Mr. Blanchflower points to a Bank of England meeting in November 2007 led by Mr. Tucker when a number of officials raised concerns that Libor submissions were lower than market rates. “He was told about the problem, but didn’t do anything about it,” Mr. Blanchflower added.

Last year Britain’s powerful Serious Fraud Office decided not to investigate Libor manipulation because it said it didn’t have the staff or resources. Now it says it will open a criminal probe.

6. The UK government’s investigation will be political theater.
UK politicians are scared of another Rupert Murdoch-like scandal, which called the ethics of its entire political system into question. There are clearly unclean hands in both major political parties with respect to Libor. Gordon Brown’s Labour party was in power during the outbreak of the financial crisis and would have wanted to see a lower rate (see 5, above.) But it was the Conservative party — now in power — who backed light-touch financial regulation in the first place. Parliament members argued about whether to have a public inquiry led by an independent judge (as happened with the Murdoch phone hacking investigation) or an investigation directed by the same regulators and politicians who’ve done nothing about Libor manipulation all this time. They chose the latter option.

7. This whole thing will cost the banks untold amounts of money.
It’s not for nothing that some are saying that this is banking’s “tobacco moment”. Barclays alone has been fined $465 million, and it was rewarded for cooperating. Several civil lawsuits have been filed, more are likely on their way.

8. Can banks afford the fallout?

Who knows? The civil cases will take time, but major damage will come from the falls in bank share prices and from penalties imposed by regulators. (In addition to Barclays, Bank of America, Citigroup, JP Morgan Chase, Deutsche Bank and UBS are all under suspicion.) There’s also the additional expense that banks will have if the scandal causes credit agencies to downgrade them. (Barclays was downgraded by S&P and Moody’s.) Many of the banks under investigation have just gone through a round of downgrades. When this happens, they end up posting additional collateral for the billions in derivatives trades to which they are party. If the crisis causes banks to be downgraded below a certain threshold it could seriously imperil their financial health.

Libor is banking’s latest breathtaking, self-inflicted injury. (Is it just me or are they happening more frequently now?) Heaven help us if it proves to be a mortal wound.

 

 

Tags: Bank of England, Barclays, BBA, British Bankers' Association, Libor

Category: Banking