Good Breakdown of the Breaking "LIBOR Scandal"
Yet more evidence that banking is no ordinary business but a sophisticated criminal enterprise...
July 03, 2012
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The LIBOR Rate-Fixing Scandal
Gaming the System
by MIKE WHITNEY
“If there is any message of the last few years, it’s that banks and bankers simply cannot be trusted.”
– Tim Price, Asset Manager at PFP Group LLP
More than a dozen of the world’s top banks are currently being investigated for manipulating the London Interbank Offered Rate or LIBOR which is used to set interest rates on more than $360 trillion of securities, including mortgages, student loans, credit cards, and swaps. So far, Barclays is the only bank to be fined ($453 million), but the probe is rapidly expanding meaning there will be more penalties to come. What the banks on the 16-member Libor panel are alleged to have done, is submit artificially low figures to keep the Libor rate down. The figures they submit are supposed to reflect their actual costs when borrowing from other leading banks. Many of them did not do that. They fudged the numbers to make it look like they were in better financial condition than they really were or to maximize their profits on derivative trades. By rigging rates, the banks defrauded investors out of tens of billions of dollars and grossly distorted the markets. Under the Sherman Antitrust Act, price fixing is a criminal offense. Someone needs to go to jail.
As of today, there are no reliable estimates of how much investors, mortgage holders, swaps traders etc may have lost by the rigging, although this back-of-the-envelope rundown by the Wall Street Journal is helpful:
“If dollar Libor is understated as much as the Journal’s analysis suggests, it would represent a roughly $45 billion break on interest payments for homeowners, companies and investors over the first four months of this year.”
Since the manipulation persisted for many years, it is reasonable to assume that the amount lost probably exceeds many hundreds of billions of dollars. Now take a look at this from Bloomberg:
“On Sept 13, 2006, a senior Barclays trader in New York e-mailed the person who submitted the rate, “Hi Guys, We got a big position in 3m libor for the next 3 days. Can we please keep the lib or fixing at 5.39 for the next few days. It would really help,” according to a CFTC document.”
Sounds a lot like the Enron tapes, doesn’t it, where traders were caught chuckling about how they had just ripped off “Grandma Millie.” It’s the same here, only worse. Since Libor is pegged to $360 trillion in securities and contracts, every bogus submission must have resulted in hefty losses for someone else.
And notice how casually the Barclay’s trader makes his request to “fix the rate at 5.39 for the next few days”? That doesn’t sound like someone who’s afraid that regulators are going
to swoop down and cart him off to the pokey for 20 years or so, does it? No, it sounds like someone who does this quite often, maybe daily. It’s all just “part of the job”. That suggests that the corruption is deep-rooted, pervasive and goes straight to the top. This isn’t just a few bad apples. The whole system’s gone haywire. Here’s a clip from the International Financing Review:
“The FSA report also shows that, between January 2005 and May 2009, around 200 requests were made to Barclays’ submitters for US dollar and yen Libor as well as Euribor by at least 14 derivatives traders. More than 30 of those requests were based on communication from outside traders, and numerous attempts were made to influence submissions from other banks.”
So, what’s going on here? Were traders just dialing up Barclays and putting in their orders for a particular rate? Keep in mind, the banks are obligated to submit the rate that reflects their own borrowing costs, not the rate that makes their trading desk the most money. And there’s another thing, too. It makes no sense for a trader to request a particular rate, unless the other banks on the 16-member panel are on board. After all, all 16 members make their submissions daily, but then the 4 highest and the 4 lowest submissions are discarded to avoid collusion. That leaves the 8 remaining submissions, the average of which becomes the daily rate. So if the banks were rigging the rate, there must have been widespread collusion. And, apparently, there was, at least according to an anonymous trader from one of Britain’s largest lenders. In an interview with the Telegraph, the trader said that the manipulation was so commonplace that,
“There was no implication of illegality. After all, there were 20 to 30 people in the room – from management to economists, structuring teams to salespeople – and more on the teleconference dial-in from across the country….. Everyone knew and everyone was doing it”.
Because Libor is so critical to the functioning of global financial markets, security is quite tight. Here’s a clip from an article in the London Review of Books:
“The co-ordinators 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. A similarly equipped building, near the office, is kept in constant readiness, and there’s a permanently staffed back-up site in a small town around 150 miles from London. Its employees periodically work in the London office, so that they’re ready to take over if need be.
The precautions are necessary because if Libor suddenly became unavailable, large parts of the global financial system would be paralysed. The 150 numbers constitute the dominant global benchmark for interest rates. The rates on borrowing, amounting to around $10 trillion (corporate loans, adjustable-rate mortgages, private student loans and so on), are pegged to Libor. For instance, the level of Libor determines the monthly payments on around half of the adjustable-rate mortgages in the US: rates are set as Libor plus a fixed margin, and are reset periodically as Libor changes.”
As it turns out, it’s not “a terrorist attack” people should be worried about, but the banks themselves who have now admitted to rigging the system for their own gain. In fact, its’ even worse than it sounds. According to the Financial Times:
“lower level Barclays’ officials “believed mistakenly that they were operating under an instruction from the Bank of England (as conveyed by senior management) to reduce Barclays’ Libor submissions”, according to the UK Financial Services Authority’s description of what happened.
Although the individuals are not identified in the documents, three people familiar with the contents confirmed that they are Mr Diamond and Mr Tucker, who heads the BoE’s financial stability arm.”
So Barclay’s CEO, Bob Diamond, believed that Paul Tucker, (Deputy governor of the Bank of England) had given him his blessing to submit bogus estimates of what it would cost Barclay’s to borrow money from other banks? Why? To bamboozle investors into thinking the system was solvent?
Well, if the Deputy governor of the Bank of England was involved in the swindle, then what about the Prime Minister? Was he in on it, too? How high does this go? This is from The Guardian:
“The focus now is on who participated in the collusion. Last May Canada’s Competition Bureau filed an affidavit against a number of banks, including HSBC Bank Canada, and Royal Bank of Scotland NV, demanding staff hand over emails and other documents.
Bureau investigators want to determine whether the banks conspired to fix derivative interest rates, a major form of market manipulation. According to the affidavit, one bank which has turned whistleblower and agreed to help the Canadian authorities with its investigation, the banks “communicated with each other… to form agreements…” which “was done for the purpose of benefiting trading positions”.
One trader at the whistleblower bank is alleged to have communicated with traders at HSBC, Deutsche Bank, RBS, JP Morgan and Citibank.
The crucial question is whether the traders were acting on their own or were doing so with the backing, or at the very least, the knowledge of senior managers. Certainly there are allegations senior management at at least one bank was aware what was happening.
A lawsuit filed in Singapore by a former RBS trader, fired by the bank, alleges it was “common practice” among RBS’s senior employees to make requests for the Libor submissions to be set at certain rates. RBS rejects the claim.
Barclays too denies that senior management were aware of what was happening on the trading desks. Diamond accepts only that a “small number” of Barclays’ traders were aware of efforts to rig a series of short-term interest rates to benefit their own desks’ trading positions.”
So, the rate fixing wasn’t just to make the banks look financially stronger then they really were. It was also to “benefit trading positions.” In other words, this wasn’t just an emergency measure to preserve the integrity of the banking system during a period of crisis. It was also to rake in record profits on derivatives contracts and credit swaps. Is it any wonder why one analyst said the allegations “confirm the prejudices of even the most hysterical anti-banking zealot”?
Indeed, it makes banking look like a vast criminal operation run by racketeers. And the notion that no “senior managers” were involved is laughable. What rookie trader would risk his career by fiddling the bank’s Libor submissions by himself? That’s nonsense. What would he gain by that; a pink slip and directions to the unemployment office? The idea is ridiculous.
Obviously, the CEO and the bigwigs in the front office were involved. They’re the only one’s who really had a motive, which was to make the bank look like it was in better financial condition than it really was and to boost profits. That’s why it was “common practice”, which is the same as saying that it was company policy. Isn’t that what it amounts to? The bank was making money by cheating.
The Libor story goes way back to May 2008, when the Wall Street Journal discovered discrepancies between Libor rates (which had been falling) and default-insurance costs (CDS) which were steadily rising. (Keep in mind, that this incredible report was published before Lehman Brothers defaulted and the financial system went into meltdown.) Journalists Carrick Mollenkamp and Mark Whitehouse had figured out that the banks “had been low-balling their borrowing rates to avoid looking desperate for cash.” By suppressing Libor rates the value of the banks’ entire portfolio of financial assets increased. Here’s an excerpt from the article:
“The Journal analysis indicates that Citigroup Inc., WestLB, HBOS, PLC, J.P. Morgan Chase JPM and UBS are among the banks that have been reporting significantly lower borrowing costs for the London interbank offered rate, or Libor, than what another market measure suggests they should be. Those five banks are members of a 16-bank panel that reports rates used to calculate Libor in dollars…
The price of default insurance isn’t a perfect indicator of a bank’s credit-worthiness…but over the longer time periods.. the data provide a good picture of investors’ assessment of the financial health of banks….
The Journal analysis shows that during the first four months of this year, (2008) the three-month borrowing rates reported by the 16 banks on the Libor panel remained, on average, within a range of only 0.06 percentage point — tiny in relation to the average dollar Libor of 3.18%.
Those reported rates “are far too similar to be believed,” says Darrell Duffie, a Stanford University finance professor. Mr. Duffie was one of three independent academics who reviewed the Journal’s methodology and findings at the paper’s request. All three said the approach was a reasonable way to analyze Libor….
David Juran, a statistics professor at Columbia University who also reviewed the methodology, says that for almost all of the 16 panel banks, the calculations show “very convincingly” that reported Libor rates are lower than what the market thinks they should be, well surpassing the threshold statisticians use to assess the significance of a result….
Citigroup interest-rate strategist Scott Peng raised similar questions in an April 10 report, writing that “Libor at times no longer represents the level at which banks extend loans to others.”
Okay, so let’s break this down into plain English.
WSJ journalists Mollenkamp and Whitehouse figured out that they could (fairly accurately) measure distortions in Libor by watching the spreads on credit default swaps. (CDS) So they ran their calculations (and methodology) by reputable statisticians and finance professors to check their work. These experts, in turn, confirmed that they were on the right track and that Libor was being manipulated. The conclusion of the article is unavoidable; that the banks were gaming the system and ripping off millions of homeowners, investors etc for tens of billions of dollars.
Now that the investigation is gaining pace and public pressure is mounting, the evidence is beginning to role in. This is from Reuters:
“On Dec. 4, according to the FSA filing, a Barclays employee who submitted the bank’s Libor costs emailed a manager: “Feeling increasingly uncomfortable about the way in which (US dollar) libors are being set by the contributor banks, Barclays included. My worry is that we (both Barclays and the contributor bank panel) are being seen to be contributing patently false rates. We are therefore being dishonest by definition and are at risk of damaging our reputation in the market and with the regulators…”
And this is from the same article:
“In late November, 2007, a Barclays employee responsible for submitting Libor borrowing costs said in an email that Libor was “not reflecting the true cost of money … Not really sure why contributors are keeping them so low but it is not a good idea at the moment to be seen to be too far away from the pack,” according to the FSA regulatory filing.”
How do you like that? Caught red-handed.
So why has it taken 4 years for the first fines to be imposed when anyone with two neurons and a frontal lobe could see that the rates were being tweaked back in 2008? Where are the regulators? Where are the criminal prosecutions? Why isn’t anyone in jail?
The stench of corruption is overpowering.
more LIBOR
August 08, 2012
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Swaps, and the Inherently Political Nature of Interest Rates
The Deep Back Story of Liborgate
by DARWIN BOND-GRAHAM
In the last four years costly interest rate swaps have become a focus of community activists and public sector unions who have watched as literally hundreds of millions, perhaps billions have been drained from the public sector. Until recently activists trying to address this crisis have been pressuring elected officials and banks, using the logic that it was the Federal Reserve’s reduction of rates that caused most swaps to turn toxic. However, because Libor is the key rate with which the majority of interest rate swap payments are calculated today, the Libor scandal has reinvigorated and transformed the moral and legal arguments that can be used by local governments seeking exits from toxic swaps. Any manipulation of Libor rates since 2007 means that swap counterparty payments linked to hundreds of trillions in public debts have been distorted, potentially to the detriment of the public, all of this on top of the already unjust depression of rates caused by the Fed. Even the stolid Financial Times has made note of this, saying that local governments burned by swaps and seeking an exit “have a point,” and that “A groundswell of such resistance should worry other banks”.
Right now there are hundreds of are accountants, researchers, and lawyers picking through paperwork and audio tapes to advance both government investigations as well as civil lawsuits against the banks that screwed with Libor. It’s going to take many long hours auditing swap payments over previous years to determine if and how the manipulation of Libor damaged specific localities and public agencies, however.
The activists I’ve spoken with who are fighting swaps in California are keenly following how the Libor scandal unfolds. The most watched arena is the Justice Department’s investigation, but there are multiple federal agencies, and foreign agencies looking into Libor. In Oakland activists have even asked their City Attorney to consider how their city can jump aboard Libor litigation that has been spearheaded by the city of Baltimore and the Hausfeld law firm.
There’s a deep back story to the Libor-municipal interest rate swap connection, part of which I’ll attempt to tell here. There’s also an important theoretical point to be made about interest rates.
First there’s the issue of why municipal interest rate swaps —instruments that were purportedly meant to hedge public debt— were ever pegged to the Libor rate in the first place. Libor, after all, was created as an index for financial transactions in the private sector, not for large public entities. In fact, when interest rate swaps were first becoming popular finance tools for cities, school districts, and public utilities, the floating rate index that was used to calculate the variable payments of the bank counterparty to the public agency were compiled from a very different and much more reasonable source – a large pool of traded public variable rate debt obligations – not Libor. In other words, the first variable index rate that swaps were calculated with was literally a measure of the average price at which major U.S. public debt was trading in the market.
This differs from Libor in two key respects. First, it’s not a hocus-pocus interest rate created by a handful of bankers out of thin air that everyone else is supposed to trust. The process was different and more approaching the ideal “markets” lionized by neoclassical economics. Prior to Libor’s dominance, the floating rates for municipal swaps were actually a measurement of a market rate. This market wasn’t entirely free of information asymmetries or big players who could swing the movement of capital by fiat, but it did mean that it was much harder for any participant to manipulate rates because they’d have to either create an incredibly enormous conspiracy of parties trading public bonds, or they’d have to try to corner a huge part of the public debt market – both very unlikely (but similar things have been done in the past). For previous rates that swaps were tied to there was more of a “market” process by which a plurality of competing parties create the rate out of a chaotic process of bidding things up and down. SIFMA’s spokespeople recently underscored this point, calling their index a “market-driven rate” as opposed to the “bank-driven” Libor.
Second, the indexes by which municipal interest rate swaps were previously priced differed in the sense that they actually were measuring average floating rates attached to public debt, rather than rates attached to variable rate debt in the private market. This real attachment to public debt made perfect sense because municipal buyers of interest rate swaps were intending to hedge against these very rates attached to their bonds and notes trading in the market.
The first index measuring public variable rate debt obligations was called the PSA Municipal Swap Index. This later became the BMA index, and later still the Securities Industry and Financial Markets Association, or SIFMA index. SIFMA, the Securities Industry and Financial Markets Association index is still around today and is used by many public agencies to price swaps.
However, by the early 2000s, Libor was eclipsing the SIFMA index as the dominant rate by which interest rate swaps for public agency debts were calculated. This triumph of Libor was due to the marketing efforts of the big banks and the financial advisers who were in the business of selling swaps to cities and public agencies. The banks promoted Libor as a superior index due to its greater liquidity, and they told public officials that by adhering to Libor they could get a better rate, thereby boosting their savings on bonds hedged with the London rate. Don’t be stupid and timid, they told public officials. The cheaper rates and bigger markets are available through Libor, and they’ll save you millions.
A 2003 report by CDR Financial Products explains the reasoning of the advisers and bankers who pressured cities to switch over to Libor:
“[U]tilizing the BMA index for swaps introduced its own problems: 1) The BMA municipal swap market is relatively illiquid. 2) The index is reset only once a week. 3) The hedging costs tended to be fairly high. Recognizing that the BMA index tended to track 1-month LIBOR (as can be seen in Chart 1), industry participants began using a percentage of LIBOR as a hedge instead of BMA to address these issues.”
What CDR’s finance gurus meant by the fact that BMA (now SIFMA) “tended to track 1-month LIBOR,” was that if you plot the long term variation of BMA to 1-month Libor, you’ll see a pattern in which they swing up and down with one another, and you’ll also notice that the spread, the amount by which they differ, has also tended to remain about the same over long periods. Almost.
By clipping 1-month Libor down to about 65 percent of its normal amount, financial analysts were able to claim that they had created a rate that was essentially equivalent to the BMA index. They were about the same rate, and would swing up and down at about the same time through the normal business cycle of the global marketplace. Almost. Discrepancies were temporary and ultimately not that important said the financial industry to public finance officials.
Replete with fancy models that demonstrated Libor’s ability to produce superior swaps that would hedge cheaper bonds, CDR Financial and their colleagues in the municipal finance advising business, as well as the big banks like JP Morgan Chase, Bank of America, and Goldman Sachs were able to convince cities to make the big switch from BMA/SIFMA to Libor.
The only serious reservation CDR Financial, and similar firms, all of who were about to make millions off the new Libor denominated municipal swap market, disclosed to cities and public agencies was that they should beware the “basis risk.” Basis risk, quite simply, is the obvious realization that Libor isn’t tracking the same thing as the BMA/SIFMA index, and Libor isn’t influenced by the same set of forces as BMA/SIFMA. The variable rates attached to public debt are quite different than the variable rates attached to bank and corporate debts. Libor doesn’t actually equal 60 to 70 percent of SIFMA. It only did this for a specific historical period. Explanations of why these indexes tracked one another rather neatly were nothing more than theories. But these warnings were delivered as an afterthought, as nothing to seriously worry about.
This is what CDR Financial told their clients:
“’Basis risk’ consists of the potentially large and damaging spread between the yield of the VRDO [the actual interest rate payments on bonds] and the percentage of LIBOR [the amount a local government would recieve from their bank counterparty that was intended to cover the VRDO on the bonds]. Over the past two years, these fears have come to fruition. The relationship between BMA and LIBOR appeared unstable; BMA as a percentage of LIBOR has increased steadily to a 52-week average of almost 85%. This has caused concern and economic hardship among issuers and spurred a desire to understand the true nature of the relationship between BMA and LIBOR.”
An especially interesting thing about the CDR Financial report cited above is that it was written by criminals. David Rubin, CDR’s president, pleaded guilty last year to federal charges that his firm stole millions from local and state governments and government agencies by rigging the bids on countless municipal derivatives contracts.
CDR’s participation in a conspiracy to defraud governments is a small part of a huge conspiracy involving dozens of big banks, financial advisers, and brokers. Rubin’s conviction was part of a sweeping Justice Department investigation of bid rigging in the municipal derivatives market. What Rubin and others essentially did was to steal millions from local governments by reducing the interest rates governments received on financial contracts like guaranteed investment contracts (GICs), specialized short term investments where cities, school districts and other public agencies park their bond proceeds between the time they receive them, and the time they actually spend them. GICs and other municipal derivatives are meant to keep bond money safe from inflation in the several years it often takes to spend it. Rubin and his friends stole public money by driving down the interest rates that cities were getting for essentially loaning their money to the banks, pocketing the difference.
Back in 2008 a number of cities such as Baltimore and Oakland, and later public agencies like the Sacramento Municipal Utilities District, filed suit against CDR and their co-conspirators. Among the dozens of other defendants are AIG, Bank of America, JP Morgan, Morgan Stanley, UBS, Well Fargo, but also “un-named” defendants that could include other major financial companies. Thebig consolidated class action case against the financial industry led by major cities and public agencies is known as In re: Municipal Derivatives Antitrust Litigation MDL 1950. It’s as about a scandalous example of major financial corporations using their power to steal public dollars by manipulating interest rates, but unlike the Libor scandal it has yet to garner as much attention from the U.S. press. Hopefully this will change as the Justice Department’s investigation, and the civil suit proceed to uncover the truth.
While CDR’s Rubin and his buddies didn’t get busted for anything directly related to the Libor manipulation, and while we’re just now only learning the full extent of the Libor scam, firms like CDR Financial were instrumental in convincing public officials to adopt Libor as the dominant rate attached to their interest rate swaps. Pehaps Rubin didn’t know Libor would become another tool used by banks to vacuum up public dollars on the sly, but Rubin and his buddies did know the general tricks of the trade.
The basis risk described by Rubin was well known when governments were adopting Libor, but the fact that the major banks that create Libor were possibly manipulating the rate to boost their balance sheets wasn’t known, and it does mean exactly what many commentators have already said – the public was cheated out of untold millions during the period of the fraud. In hindsight a lot of commentators are noting how the switch from SIFMA to Libor for municipal interest rate swaps created a lucrative arbitrage opportunity for bankers willing to bet on how the spread, the difference between the Libor rate and the actual variable rates on the underlying bonds the swaps were supposed to hedge, would move over time.
Whatever the causes of basis risk prior to the time period of the Libor conspiracy, the widening of the spread between Libor and and the actual variable rates attached to government bonds has costed the public huge sums of money. Now that we are confronted with the fact that Libor itself was prone to an easy act of manipulation by the few global banks that create it, is it fair to suggest that the banks fiddled with the rate during the financial crisis, or previously, on various occasions to produce a beneficial spread in municipal derivatives markets from which they could harvest vast sums of wealth in a manner that was almost unnoticed?
By convincing so many local governments to switch from BMA/SIFMA to Libor, firms like CDR Financial exposed local governments to the totally new problem of purposeful manipulation of the Libor rate to change spreads between variable rates attached to bonds, and the percentage of Libor agreed to in swap contracts meant to hedge these bonds.
The big switch from SIFMA/BMA to Libor points to something that’s worth talking about in more detail – the inherently political nature of interest rates.
One of the biggest problems with the reporting and commentary on the Libor scandal is the frame of “fraud,” which has guided the whole discussion. News reports and analyses have emphasized over and over again how employees of the banks that provide quotes to produce the various Libor rates criminally violated the rules. On one level this is all true, and it needs to be tracked and explained to the public so that those most responsible are shamed and made to pay for their transgressions. However, there’s a way in which this frame actually does harm to our understanding of banking and finance.
The “fraud” story, if that’s the only one we tell about Libor, leads to a very constrained debate about the concept of interest rates and the political economy of finance. We need to analyze the Libor scandal from a more historically informed position that recognizes key interest rates for what they are and always have been – privileged claims that powerful capitalist organizations make on the social production of wealth.
It has been noted that Libor was pretty much a conspiracy from its very beginning. It was never a “market-determined” rate in which actual loan prices were compiled into objective quotes. Libor was always a club of powerful banks inventing the price of money, and expecting that other banks, corporations, and even sovereign states would accept their word.
But is this really any different from any other rate of interest, be it another consortium of banks in a given market, or the rates provided by central banks? It’s hard to actually point to any interest rate ever utilized in history that was truly a product of “the market,” meaning a product a plurality of competing lenders and borrowers in which no single party, or conspiracy of parties, can significantly influence rates in their favor. Conspiracy, influence, and power are more the norm.
The actual history of finance provides countless examples of how different interest rates have been determined. Major factors in the production of interest rates have always included the power of large banks, state economic policy, wars, and central bank decisions, among other means. Small groups of especially powerful capitalists or state bureaucrats have always conspired to sabotage economies in order to direct flows of wealth to themselves or their allies.
This isn’t to say that there aren’t macroeconomic factors that generally drive rates of interest up or down. Certainly there are constraints within which the most powerful economic agents even have to operate. However, the notion that there is such a thing as a “fair market” rate of interest, and that the Libor scandal represents a criminal violation of this objective force doesn’t hold water. The Libor scandal is simply the latest example of a much longer-running phenomenon by which wealth is accumulated by those powerful enough to lift or sink rates at key moments.
Darwin Bond-Graham is a sociologist and author who lives and works in Oakland, CA. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion, forthcoming from AK Press.
A shorter version of this article appeared in Dollars and Sense.