In today’s complex financial world, borrowing rates are all around us, implicit in everything from our credit cards to our mortgages. Many of these ubiquitous financial products share a common reference rate, the London Interbank Offered Rate (or “LIBOR”), which represents banks’ near-term funding costs, and is a short term interest rate benchmark against which many floating rate loans are priced. So it’s important.
But what is it exactly?
As I learned, LIBOR is simply an aggregate of the rates at which a handful of British banks estimate they could borrow from other banks. Sounds straightforward, but at a granular level what does that mean? Thus the stage is set for the big swindle.
Examining how these rates are set and manipulated is the topic of “Open Secret: the Global Banking Conspiracy that Swindled Investors out of Billions,” by Erin Arvedlund, a financial journalist with the Philadelphia Inquirer. At a deeper level, this is a story about how the growth of global borrowing markets and financial instruments created a web of incentives that drove criminal behavior at money center banks.
What I like about the book?
I enjoyed in this book the same things I enjoy in a good Michael Lewis book: salty language, strong personalities, and outrageous behavior. It’s a great combination. Arvedlund creates a narrative flow that makes otherwise impenetrable subject matter read like a spy novel. She not only has a grasp of the financial details, but she also spins a good yarn as she lays out the history of LIBOR, and the events and people that shaped it.
In 1970, while soaking in a bathtub, an American named Evan G. Galbraith dreamed up the idea of a floating rate note, and shortly thereafter “LIBOR” appeared in a prospectus for the first time.
From its modest beginnings, LIBOR took off in popularity, based on necessity and good marketing, expanding across borders, into larger deals, and into pricing for a range financial products such as home loans and credit cards, currency options, and later into the gigantic market for swaps.
LIBOR, however, had a critical flaw from the beginning. The process for establishing LIBOR rates was based on an unregulated honor system, using an improvised, Rube Goldberg-esque, self-reporting arrangement.
I had never heard it laid out so explicitly as Arvedlund does here, but in the early days, the reporting apparatus of the banks typically consisted a couple of guys sitting around an office over sandwiches consulting some rates and literally taking a stab at it. That’s it. And here’s the thing: that never really changed as LIBOR’s use grew. It never became a regulated or formalized process, despite it’s increasing role in financial markets. So this was the basic dynamic from the beginning. Arvedlund has done some reporter-like digging on these beginnings and how this turned into a very big problem, and while the stark reality is quite stunning, it’s also somewhat understandable, given LIBOR’s informal roots.
A clubby approach like this was probably fine early on, and indeed the system seemed to work well for many years, but as LIBOR became more and more influential, incentives began to play a greater role.
Arvedlund explains how the banks began to be afraid of appearing at the high end of the range of estimates, since this sometimes raised solvency/stability questions, which then appeared in the press. As a result, the banks began to artificially lower the rate they reported, so as not to appear to be in trouble.
But the real conflicts came from trading activity. In banking there’s a so-called “chinese wall” between the buy and sell side. For instance, when I was on the sell side at GE Capital, we were instructed not to talk to our buy side, which was transacting in the bonds of sell side client companies. If the traders got wind that a company were about to issue a piece of high yield debt, they might be tipped off to trade the more senior bonds, which would be affected when this occurred. GE Capital took this very seriously. We even had creative code names for the deals to maintain secrecy.
In the case of LIBOR, there was no such wall. Or rather, there was supposed to be a wall, but it was effectively ignored. The buy side traders would literally send a chat or email to the guys setting the rate and tell them where they needed the rate to be in order to maximize trading profits.
Arvedlund details numerous emails, chats and communications showing how the traders worked the system. Some of these were borderline hilarious, including a description of how Colin Goodman, or “Lord LIBOR,” published a heavily manipulated daily “suggested LIBOR” list, but became miffed when traders ended up making all the money and he wasn’t getting compensated for his assistance. Poor Lord LIBOR couldn’t get paid. Why he wasn’t more concerned with getting thrown in prison is unclear (and which, given recent alarming reports in the press, may still occur for poor Lord LIBOR).
By 2008, with LIBOR impacting markets at the global level, including the commodities and multi-hundred trillion dollar swaps market, and the financial crisis underway, the Wall Street Journal ran a piece with the heading, “Study Casts Doubt on Key Rate: WSJ Analysis Suggests Banks May Have Reported Flawed Interest Data for Libor.”
Suddenly, the cat was out the bag, and central banks and regulators began to pay close attention. Arvedlund does a great job of giving a sense of the drama as this story unfolded, of the competing interests, and of the personalities involved.
The dogged Wall Street Journal reporters. The central banker protocols. In particular, the British central banker Sir Mervyn King came across as turning a blind eye as well as being somewhat inept and feckless. The British Banker’s Association, which had actually trademarked LIBOR, seemed more focused on maintaining control of the rate than on solving collusion problems. And many more.
Arvedlund describes how Tim Geithner, who was the New York Fed President and later became Treasury Secretary, pushed King to reform LIBOR and even provided a list of bullet point suggestions for how to address the issue, but was initially rebuffed. After all, LIBOR represented prestige and was a cash cow for the British financial establishment. LIBOR was also, however, the elephant in the room: everyone knew it was there but no one wanted to talk about it.
Another central figure in the scandal was Barclay’s CEO, Bob Diamond. While Diamond comes across as upbeat and charismatic, he displayed a rapacious hunger for success and pay at odds with his easy-going persona and a staid British banking culture. Although it was Barclay’s who purchased Lehman Brothers out of bankruptcy, thus preserving an important element of the broader financial system, Diamond was forced to resign in 2012 after an investigation into LIBOR and public outrage.
A key player who drove this resignation was Gary Gensler, head of the Commodity Futures Trading Commission. He pushed to scrap LIBOR throughout his tenure, appearing before congress over 50 times, but when faced with a sustained industry backlash eventually backed down.
In the end, LIBOR survives today, and still plays an important role in financial markets, but it is more strictly regulated than before. The irony is that despite the substantial damage caused by LIBOR rigging, which cost investors billions, it was an uphill battle all along to reform LIBOR. Nevertheless, it is undoubtedly a more reliable benchmark than previously.
After a good punchy beginning, the story kind of trailed off during the chaos of the financial crisis, the back and forth on discussions about the problem and how to fix it, and the efforts of the various regulators. I feel like Arvedlund lost the compelling narrative drive that made the beginning of the book especially good. Perhaps the subject matter became so sprawling that story necessarily became diffuse. Also, given the overall complexity of the situation, I can understand how it would be difficult to maintain a simple, coherent narrative.
Also, early on in the book, I was curious about how the trades worked, and I wished there had been some concrete examples of trades and specifically how manipulation made them profitable, although this could just be my personal bias as someone who wants to know how every finance transaction works.
Finally, in many stories, there is often a crisp resolution, but this resolution was decidedly murkier than I would have preferred. But that’s probably not Arvedlund’s fault. LIBOR today remains flawed in many ways, but then perhaps the story of LIBOR could never have a clean ending; this has nothing to do with Arvedlund’s skill as an author. At the end of the day, LIBOR includes so many elements of subjectivity in reporting and estimation that can never be fully resolved or eliminated, that there will never be a clean solution everyone can agree on that renders it somehow “fixed” in the traditional sense.
Although the ending of “Open Secret” left some loose ends for me, the book offers a extraordinary view into the inner workings of the financial system, LIBOR, and the forces striving to maintain a level playing field.
If you enjoy Michael Lewis, I’m confident you’ll like Erin Arvedlund. Her assiduous research into the LIBOR scandal, including the deep background, the blatant gaming of the system, and the cast of characters, made for a compelling read. Although it was surprising to learn about the nuts and bolts of how LIBOR is set, and read the actual communications between traders, it was also enlightening. I got a sense for why this happened — people just wanted to make money. Having read cursorily about LIBOR in the press over the past few years, I had been left with many questions, but Arvedlund’s account answered those questions, and provided me with an intuitive understanding of how we got to where we are today.
While the dust is still settling on the LIBOR scandal, and law suits are still playing out in the press, with more fines and prison sentences potentially to follow, if you are curious about LIBOR, “Open Secret” is a wonderful resource and an entertaining explanation of the LIBOR system, which continues to play a profound role in financial markets.