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The LIBOR probes - An expensive smoking gun
Apr 14th 2012 | from the print edition
Other suggestions on how to improve LIBOR welcome
IT IS supposed to be constructed using banks own honest estimates of what it
costs for them to borrow money. But regulators around the world suspect that
LIBOR (the London inter-bank offered rate), a financial benchmark that is set
every day by collating these estimates, has been subject to manipulation.
Little information has been publicly released by the regulators that are
investigating. But Canadian and American legal documents seen by The Economist
paint a picture of what is alleged. It is not pretty.
Suspicions that something was wrong with LIBOR were aroused in 2008 when
financial risks began to pick up but the benchmark, which ought to have ticked
upwards too, did not move. That same year a group of American academics
circulated a paper showing that banks individual estimates of their borrowing
costs were surprisingly close, given their different levels of risk. That
suggested something fishy but was not conclusive proof, according to Rosa
Abrantes-Metz of New York University Stern School of Business, one of the paper
s authors.
A case brought by the Canadian Competition Bureau provides harder evidence that
some banks submissions were being manipulated. The court documents suggest
that a group of traders regularly contacted one another to discuss how to
influence the yen LIBOR rate. If true, that would have breached two principles.
One is that traders from different banks should not be aligning their positions
in this way. The other is that traders are supposed to be separated from staff
within the same bank who estimate LIBOR.
The case filing summarises messages sent by Trader A , an employee of an
unnamed whistle-blowing bank. Many institutions are implicated in the document
but the following excerpt cites RBS to show how the alleged scheme worked:
Trader A explained to one RBS IRD trader who his collusive contacts were and
how he had and was going to manipulate Yen LIBOR. Trader A also communicated
his trading positions, his desire for a certain movement in Yen LIBOR and gave
instructions for the RBS IRD trader to get RBS to make Yen LIBOR submissions
consistent with Trader A s wishes. The RBS IRD trader acknowledged these
communications and confirmed that he would follow through. Trader A and the RBS
IRD trader also entered into transactions that aligned their trading interests
in regards to Yen LIBOR.
RBS says that it has legal and factual defences against such claims.
The Canadian case opens a window into how LIBOR manipulation may have happened.
Civil cases brought by banks customers in America suggest who might have
suffered if the rate was being gamed.
These cases can be grouped into four types, according to Bill Butterfield and
Anthony Maton of Hausfeld, a law firm. First, there are large individual
investment firms seeking damages on their own. The other three types of case
are brought by customers acting as groups. One group includes traders who were
on the wrong side of LIBOR bets. A second group includes investors in large
companies LIBOR-linked debt who may have lost out on interest payments if
LIBOR was set too low.
The final group is made up of customers that bought interest-rate swaps from
banks. This group includes the city of Baltimore, which is represented by
Hausfeld and whose case is especially revealing.
American cities borrow to finance the construction of large-scale public works
like roads and sewerage systems. They can borrow most cheaply at floating rates
but this option lacks the stability that fixed-rate borrowing gives. Swaps can
help them get the best of both worlds. The city first borrows at a low floating
rate. It then buys an interest-rate swap from a bank. Under the swap deal it
receives a LIBOR floating rate which cancels out the payments it must make to
investors in its debt. In exchange the city pays the bank a fixed rate.
Baltimore entered into over $100m in interest-rate swaps, according to case
documents. Lower LIBOR-linked payments to the city would have meant less money
to cover the outgoing fixed-rate payments. If LIBOR was artificially
suppressed, the city would have been losing millions annually.
If the case is upheld, damages could be big. The American cases are being
pursued under class action litigation. This means that if Baltimore s case is
upheld other cities sold the same products will also be able to claim damages.
Across America 40 states allow municipalities to enter into swap agreements.
The total estimated amount in 2010 was $250 billion-500 billion, according to
an IMF paper. What s more, cases are being brought under the Sherman Act,
America s antitrust law, which allows for triple damages. Assume the worst and
damages for American cities alone could go as high as $40 billion.
from the print edition | Finance and economics