How the penny dropped over Libor
An economist’s research into Libor in 2006 and a Wall Street Journal revelation in 2008 caused minimal ripples. Now banks face a deluge of lawsuits over their apparent collusion on rates.
The Commodities Future Trading Commission was already sniffing out traces of the Libor case while George W Bush was president. In April 2008, in a now famous revelation, the Wall Street Journal broke the first public murmur that the London Interbank Offered Rate might be “sending false signals”. Few readers cared.
But the CFTC, which had limited jurisdiction through the Eurodollar futures contract, picked up the trail from reports circulated through the President’s Working Group on Financial Markets.
Time passed. It took months of struggle to confirm Gary Gensler as head of the CFTC in May 2009, and then to find David Meister to be enforcement chief. It would take another three years to develop sufficient Libor evidence, supported by new Dodd Frank regulations that have broadened evidentiary standards for intent to defraud.
“But Gensler succeeded in bringing home the bacon. To him, manipulation is one of the worst things you can do in the derivatives market,” says Michael Greenberger, who himself served at the CFTC from 1997 to 1999, as director of the division of Trading and Markets.
Not only did Gensler thus open the door to the problem, translating the misdeeds into legal wrongdoing, but he also forged a working alliance with the Department of Justice. The DoJ, having turned a blind eye for years to subprime irregularities, was now facing such compelling worldwide evidence that it could no longer sidestep the Libor case.
Gensler, a 19-year Goldman Sachs veteran, has a profound grasp of derivatives markets. He has also earned his stripes as a serious reformer, as in 2002 when he helped engineer the Sarbanes Oxley legislation, designed to overhaul accounting oversight. Greenberger adds that Gensler “was instrumental in passing Dodd Frank, and getting its regulations up and running”.
While hotlines in 2008 among international regulators buzzed that something might be amiss with Libor, some private sector economists were also picking up the scent.
Rosa Abrantes-Metz, of Global Economics Group, operates as a sort of detective, being a global expert in financial conspiracies, cartels and manipulation. Having worked at the Federal Trade Commission from 2002 to 2004 on programmes for monitoring possible collusion in petrol prices, she has developed screens used by authorities in Mexico and Brazil.
Back in April 2008, the original Wall Street Journal articles piqued her interest, although those pieces had never specifically mentioned collusion. After retrieving Libor data and some other benchmark rates, Abrantes-Metz noted that certain strange patterns had manifested themselves earlier than the Wall Street Journal was alleging: before the credit crisis, from August 2006, and for about a year, Libor quotes from most of the submitting banks were taking exactly the same values, day in and day out.
“The quotes should have indeed been similar, but not identical,” she recalls thinking. Even odder, when the market began to reflect increasing risk Even odder, when the market began to reflect increasing risk in 2007, Libor remained unchanged and unresponsive.
The patterns could have had a perfectly legal explanation, Abrantes-Metz reasoned. While explicit coordination would be illegal, it was also possible that the banks could have been acting within lawful bounds. Since the quotes become public knowledge each day after they are set, the banks are aware of one another’s estimates; they might have converged to the same value by observing each other’s numbers.
“Typically, it’s hard to distinguish between legal and illegal coordination through empirical analysis,” she notes. “But the combination of the patterns, and the speed of movement from one quote to another made explicit coordination seem more likely.”
Abrantes-Metz first put out a joint article on the subject in August 2008, but it coincided with the turmoil over the collapse of Lehman Brothers and received little fanfare. Undeterred, she continued to flag and analyse further patterns.
Winners and losers
Wall Street regards Gensler the Reformer with a wary eye. Although he must be reconfirmed to retain his CFTC post, his success in unmasking the Libor case should make him less vulnerable to attack. The CFTC, likewise, has had to defend both its turf and its very existence. During Dodd Frank negotiations, Gensler ferociously protected the CFTC’s jurisdiction, ending up with 90 per cent of the swaps market.
Remember that the futures markets, which it regulates, traditionally derive from agricultural hedging. “Agricultural committees in House and Senate have primary jurisdiction,” Greenberger points out, noting that the lion’s share of political contributions to House members comes from financial services donors.
Financial institutions, on the other side, are girding themselves for battle. Aside from regulatory penalties, banks face another onslaught of reputational risk and the incalculable cost of private lawsuits. The notion of “too big to litigate” is losing steam. The rot has now been exposed as so pervasive that finally more judges may be prepared to act.
Libor appears to have been manipulated before 2007 at artificially high levels; even after the credit crisis, some counterparties will have lost out while others benefited. In an interest rate swap market of nearly $350 trillion notional value, plaintiffs will be raring to demonstrate injury.
Albeit an oversimplification, in a classic interest rate swap, a bank may take responsibility for the floating rate, while the borrowers pay the bank a fee based on Libor. A higher Libor, therefore, usually benefits banks, although the situation can also be reversed.
Today, counterparties feel defrauded, having been persuaded by banks to swap into fixed structures as protection against rising rates. Greenberger describes the twist as a “double insult” to counterparties, who have ended up with much higher rates while banks enjoy near-zero floating levels.
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