The LIBOR Scandal: It’s not just for the Brits any more

I’ve been trying to figure out a way to describe how serious the LIBOR scandal is without resorting to esoteric finance and economics models.  LIBOR–the London Interbank Offered Rate–is the rate at which many international banks lend money to other banks.  As such, it’s the underlying rate for prime rates around the globe.  It is akin to our Fed Funds rate.  It’s a rate watched by central banks closely and can be targeted by them.  It is not directly under their control but monetary policy can influence it.  Many, many loans are attached to the LIBOR rate and changes in the LIBOR rate.  As such, it allocates loanable funds to many many projects around the world.  It directly allocates funds to projects which–when missed–can lower the economic welfare of many countries.  Here’s just  a small bit that will give you an idea of how important the rate is from footnoted entries at Wiki.

Libor rates are calculated for ten different currencies and 15 borrowing periods ranging from overnight to one year and are published daily after 11 am (London time) by Thomson Reuters.^[4] Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor.^[5]

Companies will use LIBOR as a base rate for discounting when evaluating capital projects. This means if the rate is too high or too low, it can impact the decision to build a factory, buy a machine, or expand a project. Let’s just say that nearly every financial and economic decision that’s evaluated based on opportunity costs or discounting uses a rate that’s base on the FED funds rate or LIBOR. It’s probably the most important interest rate in the world.

I’ve promised to write on this before.  I usually have some time on Saturdays for this kind of analysis and that usually means that it may get passed over too.  Last week, there were many discussions on this and most of them had some good explanations of LIBOR basics.  Still, you have to really understand financial and economic decision making to really grok how big of a deal the LIBOR rigging scandal is and will be for some time.  You also have to understand how much our sophisticated markets depend on trust and effective regulation.  Financial markets can be opaque.  They are subject to adverse selection, principal-agent issues, information asymmetry and moral hazard.  They are also the electricity that runs the real sector.  You don’t build a car factory or a levee with out funding from some source sold in a financial market. That’s why you evaluate that decision using cash flow discounting.  For every speculator that won the bet on which way the rate would move, there was one that lost that bet too.  So, gaming the rate is like fixing the spread on every MLB game including the World Series games.

Over and over, we’ve seen that the financial markets–and the folks that participate in them–are not worthy of trust.  We’ve also had some indication that our regulation over them has not been effective.  There are many reasons for that.  Purposeful deregulation, underfunding, and ideological appointments as well as regulator capture have all played a role.

Now, we now that we have trust issues with our regulators in larger ways than we thought possible.  Once again, Timothy Geithner is playing a central role in the questions of what did the NY FED know about the LIBOR gaming and when did they know it? Major newspapers are reporting that the NY Fed was aware of this as early as 2007.  This is as scandalous as the rate gaming itself.

Federal regulators had evidence that major banks could be manipulating one of the world’s most important interest rates a year before the practice came to an end, according to documents released by the Federal Reserve Bank of New York on Friday.

As early as 2007, the officials at the New York Fed suspected that this key rate, which serves as the basis for the interest rates that consumers pay on many loans, did not accurately reflect market forces, the documents show. Then, in April 2008, the New York Fed was explicitly warned by an employee of the British bank Barclays that it was participating in a ruse to “fit in with the rest of the crowd,” referring to other major banks.

The documents, released in response to congressional inquiries, add to the mounting questions about whether federal regulators were aggressive enough in addressing irregularities at the heart of the global financial system.

The new disclosures show that the New York Fed shared its concerns about the London-based Libor rate with British regulators. But the Fed offered no evidence that it had taken additional steps, including exercising its own authority as the regulator of some of the largest U.S. financial firms, to address the rigging of the rate.

“The New York Fed helped to identify problems related to ­LIBOR and press the relevant authorities in the UK to reform this London-based rate,” the Fed said in a statement. The Fed declined to say what other steps it might have taken and is still exploring whether there are more details it can release.

The ma­nipu­la­tion by Barclays did not end until some point in 2009, offering the freshest evidence of how regulators struggled to oversee the largest banks during the global financial crisis.

Again, this is appalling.  It implies that sitting Secretary of the Treasury Timothy Geithner knew about this.  It appears that Geithner made the BOE aware of the situation by memo.  How much farther the interaction goes is unknown at this point.

The Federal Reserve and the U.S. government knew back in 2008 that Barclays was filing false reports about Libor, the interest rate that international banks charge one another for short-term loans, according to documents released Friday. The documents show that a staffer at the U.K.-based bank told the New York Federal Reserve—which was then run by current Treasury Secretary Timothy Geithner—more than four years ago about the false reports before the admission was circulated through the federal government.

Barclays has been fined about $450 million for its role in fixing the rate. The Libor (London Interbank Offered Rate) scandal has swept through the banking world, with other institutions, including Citigroup, JPMorgan Chase, the Royal Bank of Scotland and Deutsche Bank, all acknowledging that they are being investigated.

Congress is just getting up to speed on this.  Interestingly enough, it appears the driving force is Maxine Waters.

The House Financial Services Committee will get a private tutorial next week on the LIBOR scandal a day before Federal Reserve Chairman Ben Bernanke is expected to be pressed by lawmakers about the central bank’s role in overseeing Wall Street giants being investigated for possibly manipulating the benchmark interest rate.

Reps. Spencer Bachus and Barney Frank, the committee’s top Republican and Democrat, have set up a July 17 briefing for staff with the Congressional Research Service, according to a memo obtained by POLITICO that was circulated Friday to members of the Financial Services Committee.

Bernanke will testify before the committee on July 18 in a regularly scheduled hearing on monetary policy.

Some liberal lawmakers have privately been agitating for a separate hearing focused solely on the rate setting scandal instead of simply being given an opportunity to quiz officials when they come before the committee for other business.

According to a Democratic lawmaker, Rep. Maxine Waters (D-Calif.) had started to circulate a letter demanding a hearing on LIBOR but she was encouraged not to send it to Bachus and Frank.

The decision to at least temporarily forego a hearing comes as allegations of international banks manipulating the LIBOR benchmark interest rate hit Washington, D.C., this week. A newly released memo revealed that Treasury Secretary Timothy Geithner had expressed concerns about the problem as far back as 2008 during his tenure as president of the New York Federal Reserve.

The memo, sent to the head of Bank of England, Mervyn King, Geithner had made recommendations on ways to “improve the integrity and transparency of the rate-setting process.”

The big question is did the FED investigate or look into the role of its member banks in the rigging scam?  This scandal hopefully will allow us to look at the huge money center banks again and their monopoly power over so many markets.  I’ll be following this closely.