BLOG OF THE DAY: Giving the Lie to LIBOR

If the big banks started gaming LIBOR to save face, did they continue doing it to make money?

It’s been widely believed for some time that during the throes of the financial crisis, several megabanks underreported their own hypothetical borrowing costs in the British Bankers Association survey used to calculate the London Interbank Offered Rate. Regulators have been probing the alleged manipulation.

I’ve long assumed the motivation for a bank to give a b.s. quote in the survey was to save face, to avoid looking weak and thereby triggering (or propelling) a run. Lowering LIBOR (an index that serves as a pricing benchmark on all manner of loans and bonds) would thus be a mere by-product of the bankers’ baloney – and a welcome one for borrowers the world over.

So I was skeptical when I first read Charles Schwab Corp.’s suit from August alleging that global banks colluded to manipulate LIBOR for ill-gotten profit. Schwab, which purchased floating-rate securities from several banks, alleged that those institutions acted in concert to depress the index so the bonds would pay a lower rate of return. Like most conspiracy theories, this one initially struck me as farfetched.

But a very interesting post Tuesday by Donald R. van Deventer, CEO of the risk management consultancy Kamakura, offers statistical evidence to support this interpretation of events.

Among other number-crunching exercises, van Deventer compared Federal Reserve data on three-month Eurodollar rates during the period covered by the Schwab suite to banks’ self-reported costs in the LIBOR survey of that maturity in the same timeframe. LIBOR is based on banks’ quotes of what they hypothetically would have to pay for interbank loans. The Eurodollar rates are presumed to show what banks actually have paid for money, on average. (The Fed gets its data from ICAP, an active broker of Eurodollars). Theoretically, these two figures should track each other closely.

Yet beginning in 2007, Van Deventer finds major discrepancies. The Fed’s figure far exceeded several banks’ claims of what their borrowing costs were. Again, one could surmise that the banks were simply trying to stem a panic by denying how bad things were. But if that were the only motivation, the difference should have narrowed sometime after the Tarp bailouts of October 2008, which calmed markets. Rather, banks’ self-reported, hypothetical borrowing costs continued to come in far below the Fed’s Eurodollar market indications well into 2009. 

“It is highly likely,” van Deventer concludes, that evidence Schwab’s lawyers turn up in discovery, like internal bank data and “gotcha” emails, “will confirm that the banks tacitly manipulated Libor downward by collective lowering of quotations.”

Van Deventer maintains that this manipulation hurt any party that had agreed to pay fixed rates in interest rate swaps, since the Libor-pegged floating rates they received in return were artificially low. So there’s no free lunch here. If homeowners who took out adjustable-rate mortgages got an inadvertent break, corporate treasurers prudently trying to match their companies’ assets and liabilities may have been hosed.