The picture is starting to emerge on the severity of LIBOR scandal

The Economist has a very depressing article that describes the range and depth of the LIBOR disaster: The rotten heart of finance.  If you are following LIBOR scandal, you will really want to read this article. Be forewarned it makes for sad reading.

There are two different ways LIBOR rates have been manipulated.

First is a longer running and less severe manipulation. For number of years, at least since 2008, perhaps as long ago as 2005, and perhaps even earlier, the article says traders inside the banks have been moving the rate a little bit. Second is a larger amount of movement for a shorter period of time. This took place during the financial crisis of 2008 in order to understate borrowing costs.

The first, longer running manipulation

The apparent motivation for the first, longer running manipulation is to make small profits on daily trades.

The first sort, and the one that has raised the most ire, involved groups of derivatives traders at Barclays and several other unnamed banks trying to influence the final LIBOR fixing to increase profits (or reduce losses) on their derivative exposures.

How often did this happen? The article says:

In settlements with the Financial Services Authority (FSA) in Britain and America’s Department of Justice, Barclays accepted that its traders had manipulated rates on hundreds of occasions.

The behavior was quite open, to the degree that one trader would shout out how he wanted to manipulate the rate to find out if someone else had a manipulation target in conflict with his:

Yet the brazenness with which employees on various Barclays trading floors colluded, both with one another and with traders from other banks, suggests that this sort of behaviour was, if not widespread, at least widely tolerated. Traders happily put in writing requests that were either illegal or, at the very least, morally questionable. In one instance a trader would regularly shout out to colleagues that he was trying to manipulate the rate to a particular level, to check whether they had any conflicting requests.

How would this pay off?

Picture what you could do if this afternoon you could artificially nudge tomorrow’s Dow Jones Industrial Average up or down a couple of points.

If you could push a rate, say the nine-month LIBOR for the British pound, for tomorrow down by 0.01% or 0.02% below where it really would be, and knew that information to help with today’s trading, you could make some serious money.

The second, more intense but shorter manipulation

It is emerging that Barclays and a number of other banks lowered their reported borrowing costs during the depths of the financial crisis. The article says:

Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average. That could create the biggest liabilities for the banks involved (although there is also a twist in this part of the story involving the regulators).

The amount of manipulation here, 0.30% or 0.40%, is a lot.

This is where Barclays says they told their banking regulator, the Financial Services Authority, that other banks were submitting incorrect data.  All the press reports I’ve read acknowledge that Barclays did talk to the FSA and other regulators.  A huge tangent here is that Barclays thought they had a wink and nudge approval from FSA to under report their costs.

What is the point of underreporting your borrowing costs during the financial crisis? It makes you look better.

If other banks are increasing the rate they charge you a lot, is because they are concerned you may not survive. So if someone is reporting unusually high borrowing costs during the financial crisis that means that bank is less likely to make it through the crisis. Thus, you misreport your numbers so you can stay alive.

Here is more background:

In their article, Embattled FSA Is Under Fire for Libor Policing, the Wall Street Journal indicates the British regulator, Financial Services Authority, was not monitoring and regulating LIBOR.

The article indicates that Barclays had been telling FSA they believed there were problems in the calculation LIBOR as far back as 2007.

Another WSJ article, Traders’ Messages Provide Grist for Investigators, gives more background on the range of regulators looking at the issue and the depth of the issue:

The sprawling probe of at least 16 other banks and financial institutions includes three criminal and about 10 civil investigations in North America, Europe and Asia, according to regulatory filings and government officials.

The LIBOR scandal is bad already and I think it will get worse.

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