Opinion and Investing Column

KIM: Why the Libor lie matters to the man on the street

September 1, 2012

KimLibor, the London interbank offered rate, certainly sounds like an obscure, technical bit of financial jargon. However, Libor directly affects the pricing of more than $800 trillion in securities and loans. In fact, the British Bankers’ Association, the trade group overseeing Libor, has called it “the most important number in the world.”

Libor is supposed to measure what it costs banks to borrow from one another. A group of the largest global banks is polled daily as to their estimate of how much it would cost them to borrow in 10 currencies for 15 maturities ranging from overnight up to one year. An agent for the BBA collects and sorts the estimates. The highest and lowest 25 percent are thrown out and the middle 50 percent are averaged. Voila! You have the Libor for that day, all 150 of them.

Pricing of loans, credit instruments and credit derivatives are oftentimes determined by adding a stated interest rate spread to Libor. If you have a credit card, mortgage, or own shares of a money market fund, the interest you pay or earn is directly affected by Libor. If you’re a company issuing commercial paper, Libor determines your cost of borrowing. Similarly, a municipality or hospital seeking protection from future interest rate increases might enter into an interest rate swap with a financial institution, the value of which is also directly affected by Libor.

Given that Libor is a key part of the foundation of credit markets and has a pervasive impact on individuals, corporations, governments and policymakers worldwide, you’d think Libor and the process of setting it would be subject to the highest level of scrutiny, regulation and oversight.

You’d be wrong.

As it turns out, the manipulation of Libor has been going on for years. Given the BBA had sole authority over the process of setting Libor and depended on banks’ submitting their own estimates of borrowing costs, it was relative child’s play to manipulate Libor. There was no need for sophisticated technology or cloak-and-dagger tactics.

Apparently, all it took was an e-mail from a bank’s trading desk, which buys and sells securities priced according to Libor, to the bank’s treasury desk, which submits the bank’s estimates of its borrowing costs. The following e-mail was sent on Sept. 13, 2006, from a Barclays PLC senior trader to the Barclays treasury desk: “Hi guys. We got a big position in 3m libor for the next 3 days. Can we please keep the libor fixing at 5.39 for the next few days. It would really help. We do not want to fix it any higher than that. Tks a lot.”

Fast-forwarding two years to the depths of the global financial crisis, Barclays apparently intentionally understated its borrowing cost estimate, fearing a higher (and more accurate) estimate would signal it was in dire financial straits.

Unfortunately, this was not a dastardly deed committed by a few rogue employees at one bank. Barclays agreed to pay $450 million in June to settle charges with American and British authorities, but there may be 10 or more banks implicated as the investigation continues. You will recognize all the names.

The Libor lie is yet another threat to the very integrity of the financial markets and must be fixed. Expect to see more on this unfolding scandal in the coming weeks.•

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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Ind. He can be reached at (812) 376-9444 or mickey@kirrmar.com.

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