The Ongoing LIBOR Scandal

One way New York City stimulates its residents is with hundreds of educational and cultural events, more in a day than anyone could attend in a year. Today I chose to be educated at a discussion offered by The Zicklin School of Business at Baruch College on the LIBOR scandal, headed "Are They Still Playing Games in London?"

First in the fall 2012 series of the Robert Zicklin Center for Corporate Integrity, the discussion is led  by David Rosenberg, Associate Professor of Law and associate director of the Center. He interviewed Peter Eavis, a business investigative reporter for The New York Times and before that a reporter for  TheStreet.com, Fortune and The Wall Street Journal. He won a Loeb Award for commentary in 2005 for articles spelling out the accounting troubles at Fannie Mae. He was early in spotting problems with Enron's books and he uncovered accounting issues at Conseco, Qwest and Amazon.com.  A British national, Mr. Eavis was born in Canada and graduated from Leeds University in the UK. Here are the highlights of the narrative, delivered mostly by Mr. Eavis:

LIBOR, the London Interbank Offered Rate, is supposed to be the interest rate at which banks lend to one another. Someone calls around in the morning and asks what rate each bank could borrow in different currencies and 15 different maturities, from overnight to 12 months. The "panel banks" are selected by the British Bankers Association. The highest and lowest 25 percent are eliminated and the other 50 percent are averaged by Thomson Reuters.

Trouble is, the loan market dried up in 2007. The concept depends on there being an active market for loans. In 2007, banks began worrying more about their balance sheets and put their money into government bonds instead of riskier loans.

Banks completely stopped lending to one another.  If a bank needed funds, it borrowed from the European Central Bank or the Bank of England. The LIBOR continued to be published, but the numbers were just made up. So what else is new? A lot of indicators are based on surveys that amount to opinions. But it gets worse.

During the banking crisis of 2008, LIBOR was systematically understated. In order to appear more solvent than they were, banks quoted low rates like 1 percent for the 3-month LIBOR whereas in fact they would have to pay a lot more assuming they could get a loan at all.

Reuters journalist Carrick Mollenkamp in April 2008 noted the low-balling problem.  He said it was widely known on Canary Wharf that the LIBOR was fictional. The bank regulators (especially the British financial overseers and the Federal Reserve Bank of NY) started investigation. The low quoted rates gave people confidence that the banks were in better shape than they really were. This bought some time and is the positive side of what happened. Some argue that this was like moving the lines of the football field - it was still a fair game. But people made decisions relying on information that many other players knew was false. And it gets worse.

A much worse problem is that traders were influencing the LIBOR estimates to make profits. The U.S. Commodities Futures Trading Commission suspected something was amiss and demanded an investigation by Barclays. Complying fully with the request, Barclays provided emails of traders talking with one another about modifying the LIBOR to help interest-linked derivatives (options, swaps, futures) make a profit when they came due. When the Barclays report was released it caused a firestorm in the UK. Barclays paid a $450 million fine and senior managers were forced out.

How was corporate integrity compromised so broadly? "Everyone was doing it." (Rosenberg)
"Small differences in rates, no one seemed to be hurt." (Eavis) But others ask: "Why has no one gone to jail?" (Eavis)

Some "very strange" outcomes and messages.
1. LIBOR continues to be published. A commission to replace it hasn't done it yet.
2. The major message for traders - use the phone, not emails. 
3. Another message - maybe don't comply with data requests so energetically. On the other hand, Barclays might have been treated even more harshly if they had not been cooperative.
4. Some feel the crime was victimless, but by creating winners they also created losers. U.S. municipalities are figuring out how they were hurt; in some cases it is obvious and big-time.

What lies ahead.
1. More lawsuits and government action. The NY State Superintendent of Financial Institutions broke from the pack and went after Standard Chartered, sponsor of the Liverpool Football team. He won't be the last.
2. Dodd-Frank requires more transparency. Derivatives will have to be on more transparent platforms.
3. LIBOR will be replaced.

DOWN DOWS | Cognitive Dissonance 2

July 11, 2008–On Nov. 8 last year, in DOWN DOWS | Cognitive Dissonance  and then on  Nov. 8 in  Huffington Post, I noted that Bob Janjuah of the Royal Bank of Scotland had raised the upper end of his estimate of cumulative subprime write downs. His estimate was $500 billion at a time when losses of just $50 billion were acknowledged by institutions. Now Janjuah looks like an optimist:

1. Bridgewater Associates, the world's second-largest hedge fund, has estimated likely asset writedowns at $1.6 trillion, i.e., a 6 percent overvaluation of $26.6 trillion of risky credit-based U.S. assets (mortgages, credit receivables and credit-card receivables). Some bankruptcies are predicted.

2. David Rosenberg, Merrill's Chief North American Economist, argues in a July slide show that more bad news is in store:
- A recession? We're in it. Just a question of how bad it gets and for how long.
- Asset values? Not yet priced low enough to reflect the recession.
- Housing prices? Could fall another 20 percent.
He therefore believes that while stagflation is the problem today, tomorrow it will be deflation and Fed policy must therefore remain accommodative.

Recent declines in the Dow are closing the disconnect I noted on Nov. 8 between the debt and equity markets. But the months ahead will be challenging for private investors and government officials at all levels.