London Inter-Bank Offered Rate

LIBOR is the “London Inter-Bank Offered Rate,” or the estimated rate that the leading London banks would have to pay if borrowing from another bank. As the primary benchmark for short-term interest rates in the world, a staggering number of financial instruments are tied to Libor, both in the financial markets and commercial fields. Forward rate agreements, interest rate swaps, variable rate mortgages, term loans, collateralized debt obligations and a variety of other instruments all use Libor as a reference rate, and as a result it’s impossible to tell the total value of the instruments riding on Libor. The rate underpins $300 trillion in instruments by conservative estimates; as much as $800 trillion by some reckoning.

Instruments are things like Mortgage-Backed Securities. When a home loan is approved, it usually has the blessing of a loan underwriter. In some cases, this is the FHA, or Freddie Mac, or Fannie Mae, depending upon the amount of the loan and the quality of the collateral, including the creditworthiness of the borrower. That loan is packaged with other loans into blocks that are sold by the original lender for a service release premium, or at a slight discount to recapitalize the lender. The buyer of those loans receives the payments for a short while, perhaps a year, and then the block may be sold again further up the line. Each time that block is added to the asset report of the buyer, fully underwritten, that buyer can derive value from it and loan out up to ten times that amount to someone else.

If you have ever paid on a mortgage for more than 5 years, you probably changed the recipient on the house payment a couple of times. That is what is going on. Your first mortgage is the instrument that is being traded. If you stop making your payments, and don’t sell the home for at least what you bought it for, the owner of that loan has to sell off the 90% derivative he bought with your loan because the collateral is in default.

Hundreds of defaulted loans is disruptive to the market. Tens of thousands of defaulted loans can collapse the derivative structure. Hundreds of thousands of defaults can collapse the entire money supply. There are only two things that can be done to save the house of cards. One, print money. Lots of it. Two, bail out the lender by making up the difference between the fire sale and the principal amount of the defaulted loans.

Oh yeah, there is a third thing. They can do a bail in. This is where they take from the depositors of the bank, say all the money that is not NDIC insured, and make up the difference bank by bank. BY the way, if your account is a “no fee” account, it is probably associated with a money market fund. That means you approve the bank to buy and sell currencies with your money during the hours the bank is closed. Any funds associated with a money market fund are not NDIC insured. Any funds over $100,00 in some case and $250,000 in certain cases ultimately belong to the bank.

            Now, what role does LIBOR play in the true value of these derivatives? The most important word from the entire description above about LIBOR is “estimated.” Libor is the “estimated” rate that leading London banks pay for inter-bank borrowing. Banks buy cash from eachother, depending upon liquidity and the spread between the interest of the loan and the cost of the funds. This estimate is compiled as the average answer among a panel of banks prior to 11 am on that business day. The answer to that question is a self-reported figure that does not need to be cross-checked against any real world figures; you would think it would be a simple result of a contracted math formula, but instead it is based on honesty and trust. The four high and four low figures are thrown out and the rest are averaged, yielding a mean rate that is then reported as the Libor figure for that particular currency (e.g. USD) in that particular loan period (e.g. overnight). The mean rate is NOT the average. It is the center value.

            Well, any time you mix the words honesty and trust with the word banker, you have a real problem on your hands. As you can imagine, the temptation to manipulate the numbers suit the whims of banks in general and traders in particular was too great to resist; especially since the Obama Justice Department hadn’t arrested anyone for high-level financial crime. No one. Not John Corzine. Not the naked short traders. No one.

The temptation to manipulate the rates could come in numerous ways from different places: derivatives traders would often find ways of pressuring those employees who submitted the rates to raise or lower the rate to suit their trading positions; sometimes the traders would actually fill in for sick or absent employees and submit the rates themselves. This is illegal and a conflict of interest. It would be like giving you the label printer for the grocery when you go shopping. Oops, the price of ribeyes today was only 50 cents per pound. For me.

Barclays Bank admitted that it lowballed its rates because it feared that its rival banks did the same and they would appear to be in trouble if they were consistently quoting higher rates. The most serious accusation to emerge from the entire scandal was that a 2008 conversation between Bank of England Deputy Governor Paul Tucker and Barclays CEO Bob Diamond left the bank with the impression that they had a blank check to manipulate their rates downward in order to give an overall better impression of the banks’ health in the wake of the 2008 crisis.

The Libor interest-rate scandal dates back to 2005 and involved trillions of pounds worth of loans, mortgages and financial contracts in Europe and the US. In other words, while you were losing your home, or scooping a cheap home at a bank asset fire sale, and shrugging off the biggest taxpayer ripoff in history, the highest level bankers were watching billions funnel into their accounts.

Regulators have already imposed £1.7bn of fines on a string of the world's biggest banks, while police are pursuing criminal investigations into staff involved in rigging the rates to suit their employers. This is just the cost of doing business. No one went to jail. Let’s see how the timeline plays out.

Between January 2005 and June 2009, Barclays derivatives traders made a total of 257 requests to fix Libor and Euribor rates. Initially, traders sought to inflate the bank lending rate to boost profits – and their own bonuses.

After Northern Rock collapses, Barclays submits artificially low rates to give a healthier picture of its ability to raise funds.

In a phone call in December, a Barclays employee tells the New York Fed that the Libor rate was being fixed at a level that was unrealistically low.

2008

In April the New York Fed queries a Barclays employee over Libor reporting.

The Wall Street Journal publishes the first article questioning the integrity of Libor.

Following the WSJ report, Barclays is contacted by the British Bankers' Association over concerns about the accuracy of its Libor submissions.

Later in the year, the Fed meets to begin inquiry. Fed boss Tim Geithner gives Bank of England governor Sir Mervyn King a note listing proposals to tackle Libor problems.

2009

A year on, the BBA issues guidelines for setting Libor rates.

In June, Barclays makes first effort to clamp down on Libor manipulation in email setting out standards of behaviour.