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Terry Connelly


Let Me Bore You With Tales of LIBOR -- or is it "LIE-BOR"?

Posted: 07/14/2012 4:03 pm

The next banking industry scandal to wash ashore in the US from Europe will be the matter of two periods of chicanery in the private association of global banks that set the basis for the so-called "LIBOR" interest rate - the benchmark used to calculate interest payments due on literally trillions of debt instruments including massive amounts of American mortgages, auto loans, credit card balances and student loans, to name a few!

LIBOR stands for the 'London Inter-Bank Offered Rate" by which means a series of complex arithmetic calculations undertaken by a unit of Reuters under contract with the London Bankers Association, a private, non-governmental entity that collects input daily from member banks supposedly on the rate of interest each bank estimates it would pay to borrow for maturities from overnight to several years. The result is supposed to be a good-faith sort of average of such rates per maturity that then hold for one business day until the next morning's calculation. On this the world of finance has turned for decades, more and more debt instruments utilizes the LIBOR rate applicable to a particular maturity, or an average over time like 30 days of such rates, as a basis for both floating rate and fixed rate interest calculations.

LIBOR, or perhaps more precisely the trend in fluctuations in LIBOR, can also herald significant value changes in certain derivative instruments, including our old friend from the mortgage market meltdown, the credit default swaps (CDS's) that daily signal the credit standing of the banks whose debt they are written on. These pseudo-insurance instruments that basically are intended to pay out to the holder (from the counter-party) in the event that the bank suffers a default event on its debt.

As you may know by now, these CDS's, unlike normal insurance, are really betting chips played in the trading markets across the globe every day. Traders in banks make bets on them like other market participants. And it turns out that some traders at Barclays in London (where else?) and perhaps other major banks, figured out a way to manipulate LIBOR, falsifying the supposedly good-faith submissions to the Bankers Association as to their true borrowing costs, in ways that would affect the market for CDS's on various banks. No wonder Warren Buffet referred to such derivatives as instruments of mass financial destruction. No surprise to see them back at the heart of another banking scandal.

Sometimes the traders false submission of rates actually made their won banks look bad in the private trading world of the Bankers Association, but who cared if they were making tons of money in the derivatives market as a result of swings in LIBOR calculations that other market participants may not have expected. These traders expected them, because they had secretly rigged the outcome of the arithmetic calculations: LIBOR, literally, became LIE-BOR.

The lying went on apparently from 2005 onward into 2008. Whom did it hurt? Depends on what side of the transaction you were on - either in the market from debt directly affected by LIBOR itself, or in the derivatives markets for CDS's on global banks. For many, an artificially low LIBOR rate actually made them innocent bystander beneficiaries, because their own interest rate payments (say, LIBOR plus 3.75 % or 8.50 % or whatever) would turn out lower. But the reverse could be the case, and so whether the borrower or the lender was "cheated' by the third-party actions of the bad-guy bank traders. The parties themselves to the debt transaction based on LIBOR presumably can't sue each other, because neither side was to blame for the false LIBOR price tag for the money borrowed.

And there was yet another twist to the LIBOR game at the depths of the financial crisis in 2008. LIBOR itself, false or true, was going through the roof as many banks throughout the world were having trouble getting credit from other banks, period! YET reported LIBOR seemed even at that to be artificially low in terms of reflecting actual lending among banks, when everyone knew not much of it was really going on.

The Wall Street Journal raised questions about the validity of LIBOR as a benchmark at the time, and it appears now that some banks (including by its own admission, Barclays) were indeed putting in artificially low numbers for its borrowing costs, lest the world (and particularly the CDS market) come to think that they couldn't obtain credit in the inter-bank market at all - the kiss of death from any major league financial institution. The Bank of England it seems nosed around about the issue at that time, too. But the BOE now says to Parliament, through its deputy head, that they were concerned about the inherent unreliability of LIBOR calculations in the unstable overnight lending market - the "credit freeze" that accompanied the mortgage finance meltdown - than they were about the possibility of actual fraudulent submissions.

The Commodity Futures Trading regulator in the US (the "CFTC") has led our Government's inquiry into this double-barreled mess over the past few months, and has succeeded in getting Barclays to come clean and pay a huge settlement. Not to be outdone, the British authorities and Parliament have now also demanded the heads of Barclays' CEO (the American Bob Diamond), its COO and ultimately its Chairman once he gets done hiring a new CEO. Questions about the trading culture at Barclays and possibly other banks fill the political channels, but the bigger questions may turn out to be "what did the US Federal Reserve know, and when did it know it?" According to the Wall Street Journal, the matter was called to the Fed's attention as early as 2007. Congress is unlikely to ignore yet another opportunity to grill Tim Geithner (then the head of the New York Fed) and Ben Bernanke, then as now, the Chairman of the Reserve Bank Board.

These questions will also rebound on to the heads of JP Morgan (which announces the financial fallout from its own whale of a trading problem in London this Friday the 13th), Citigroup and perhaps other US banks.

Unlike the mortgage mess that both followed and preceded the LIBOR lies, the victims here are probably not the borrowers so much as the auto, mortgage and student loan and credit card lenders, especially beginning in 2008 when some banks were trying to report LIBOR as artificially low. The real victim is the market in banking integrity (yet again), and probably LIBOR itself, which has proven to be all too easy to manipulate to trading advantage. As long as there are CDS's written on banks available for bets in the casino we call a global financial market, the temptation to corrupt a pivotal, private association calculation like LIBOR are too much for the trading class to resist. The only alternative may be a conditionally transparent disclosure of actual borrowing rates among banks to a central, government-supervised yet confidential rate-setting authority that is itself subject to external audit.

Stay tuned - this subject is clearly complicated, but since trillions of dollars in liabilities are at stake, the subject must be mastered. Maybe we have a chance at that, as the scandal clearly spans two distinct US Administrations, so mutual interest may yield a truce in some of the political rhetoric and maybe we can get to the boom of the problem. But don't hold your breath!


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