LIBOR scandal exposes the ugly side of banking

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Nick Massey is a financial columnist for The Edmond (Okla.) Sun.

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July 19, 2012

LIBOR scandal exposes the ugly side of banking

Anonymous CNHI The Bluefield Daily Telegraph Thu Jul 19, 2012, 10:33 AM EDT

It seems there is no shortage of financial scandals to write about these days. By now you have no doubt heard about the latest financial scandal involving LIBOR, the London InterBank Offering Rate.

From a writer’s standpoint, this is like the gift that keeps on giving. You can’t make this stuff up.

Barclays Bank admitted to manipulating LIBOR in 2008, at the height of the financial crisis. Their excuse? Not only did they get the hint from the Bank of England that they should hold LIBOR lower than it would otherwise be, but they said almost everyone else was in on the game too. Well, maybe not everyone.

For those not familiar with it, many bank loans around the world use LIBOR as a benchmark for the interest rate charged on a given loan. It will usually be expressed as LIBOR plus a certain percent. Trillions of dollars in loans are tied to LIBOR in some way.

So why is this scandal such a big deal? Borrowers who have loans outstanding at LIBOR or LIBOR-plus got a good deal. This includes many Americans who financed their homes on an adjustable rate, which was usually the prevailing LIBOR plus some number, like 2.25 percent.

With LIBOR held lower, borrowers paid less interest. For a borrower, this is a good thing. However, if you were the lender, it was not so good.

Many of these types of loans are included in securitized baskets of mortgages that were bought up by pension funds, insurance companies, and others. These institutions became the lenders to many of the borrowers - the homeowners.

So as homeowners got the gift of paying a lower interest rate than they should have, the lenders – the pension funds and insurance companies – got less than they should have received. So we have pensioners, insurance contract holders, and other fixed income investors that basically had their interest stolen from them.

The magazine “The Economist” recently wrote that Bob Diamond (Barclays CEO)...retorted in a memo to staff that “on the majority of days, no requests were made at all” to manipulate the rate. This was rather like an adulterer saying that he was faithful on most days.”

Attempts to manipulate free markets invariably end badly.

Let’s take a look at how LIBOR works. LIBOR is actually not just one interest rate. It is the name for rates calculated in 15 currencies for loans of 10 different maturities, ranging from overnight to 12-months.

The setting of LIBOR begins each morning in London when someone in one of the designated LIBOR panel banks enters a number into a piece of Thomson Reuters software that asks the question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11am?”

Without going into extreme boring detail, suffice it to say that numbers are submitted by many banks and the highest and lowest 25 percent are thrown out. The middle 50 percent are then averaged, producing a figure that is published as that day’s LIBOR.

Think about this for a moment and notice the obvious. Given that almost half the reported inputs that help establish the LIBOR rate are discarded immediately, Barclays simply could not have manipulated the LIBOR rate alone. Plenty of people were in on the scam.

If you were trying to manipulate LIBOR alone, to effectively insure the rate is set at the price required, you’d need to not only establish the highest and lowest 25 percent of prices, but then insure the remaining 50 percent average out to the required rate. Based on the fact that there are 16 banks that submit rates, about 13 of the 16 involved would need to be complicit.

At best this is a cartel, at worst it is outright fraud on a scale that is completely unprecedented. Which is it? OK... I guess that answers that question.

Forget “too big to fail.” Was this “too deep to prove?” Let’s all shout the Latin phrase “Fiat Lux” – Let There Be Light!

You can expect lots of fireworks from this situation in the weeks and months ahead, and expect it to “jump the pond” to the US as we see our American banks pulled into the fray. Stay tuned.

What does it mean to you? Most likely a financial sector under more pressure and one more reason to cast a wary eye towards the equity markets.

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Nick Massey is a financial columnist for The Edmond (Okla.) Sun. Contact him at www.nickmassey.com.