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The global investment community has been brought to the edge more than a few times in recent years. Last week a disturbing scandal emerged about the leading global benchmark interest rate, from which all others are derived, known as Libor (London Interbank Offered Rate). Libor is used to influence interest rates on everything from corporate debt to car loans.
It is suppose to reflect the rates that banks charge one another for short-term loans. It is a benchmark used by institutions around the world and once a member bank, one has total access to the daily posted rates.
This means that, as a member bank, one can borrow a grand amount of short-term money at the designated rate (rate dictated by the member banks). It is a major influence behind virtually all economic activity and considered to be the world’s most important financial instrument.
In respect to this most recent scandal, surrounding Barclays and the schematics of ‘rigged rates’ involving the Libor, there is much to learn.
News first broke last week that Barclays was directly involved in the manipulative influence over the Libor, which is the average interest rate estimated by leading banks in London that they will charge to other banks wishing to borrow funds.
This has global repercussions as the confidence in our banking and financial systems continue to be undermined by widespread corruption and manipulation. This is bringing us to a tipping point in our financial system as an overall market distrust is taking form. These types of bellwether events routinely occur before crisis ‘choke points’ as pressure in the system mounts.
It is important to note that a dozen other banks are currently being investigated for submissions they made used to calculate Libor rates. Barclays was simply the first to settle.
Before we elaborate on why you need to be concerned about this Libor scandal, let’s first explain, in more detail, what the Libor is and why it was created.
Investopedia defines the Libor:
“The LIBOR is the world’s most widely used benchmark for short-term interest rates. It’s important because it is the rate at which the world’s most preferred borrowers are able to borrow money.”
The creation of LIBOR (according to global-rates.com)
At the start of the nineteen eighties there was a growing need amongst the financial institutions in London for a benchmark for lending rates. This benchmark was particularly needed in order to calculate prices for financial products such as interest swaps and options. Under the leadership of the BBA a number of steps were taken from 1984 onwards which led in 1986 to the publication of the first LIBOR interest rates (bbalibor).
In 1984, banks began trading actively in a variety of relatively new market instruments. Interest rate swaps, foreign currency options and forward rate agreements were growing with rapid popularity. Bankers lusted for more instruments and higher profit margins and unlike the derivatives market, someone thought a little control might be in order.
As these new financial instruments brought greater depth to the London Interbank market, which in 1984 was the global powerhouse for investment, these bankers began to worry about supporting future growth. These ‘Wild West’ conditions could not last and with expansion came a degree of regulation – or so they thought.
A measure of uniformity was introduced. The premise was simple: Top global banks from around the world would submit their best short-term rates and using these figures, a benchmark interest rate would be determined, which all other member banks would be able to tap. This would set a universal lending rate, crystal clear for which everyone could gauge (this is the Libor).
What today’s scandal revolves around is member banks, namely Barclays, have been accused of fudging their individual interest rates to achieve an end, of one form or another. Barclays, and possibly many other banks (roughly a dozen under investigation), have had motivation, or pressure from various sources, to influence the Libor rate to be lower or higher at specific times.
This is market manipulation on a grandiose scale because of how far reaching Libor is. It touches all parts of the global economy in one form or another.
Member banks of the Libor are international in scope, with 223 members and 37 associated professional firms. Over sixty nations represent these members and professional firms.
Libor is set in 10 different currencies, in maturities ranging from overnight to 12 months. Unlike US Treasuries, which give access to long-term rates of 10 and 20 years, the Libor rate is specifically for short-term rates. Its impact on the economy is immediate.
Recently, Barclays has been accused of fudging the numbers and submitting lower or higher rates in an effort to manipulate the Libor rate. The actual facts on how much interest rates were manipulated, and who benefited, is yet to surface.
However, with CEOs running and hiding and fines of $200 plus million already being quickly paid, you just know there were billions, if not trillions, of dollars in economic manipulation. Barclays was fined £290m by UK and US regulators for ‘attempting’ to rig the rate between 2005 and 2009.
Sadly, this is not the first time Libor has come under fire. During and after the financial crisis, evidence emerged that banks were understating rates. Although many possibilities exist, it was thought at the time that member banks were submitting lower rates to hide how they were being viewed. Higher rates perceive greater risk.
In 2011, many of the U.S. and European banks, which provide borrowing costs to calculate the Libor every day, were investigated by the Department of Justice, Securities and Exchange Commission, and the Commodity Futures Trading Commission.
As disgusting and discouraging as this Libor rate manipulation scandal is, for a moment, let’s put that aside. We need to understand the history of the Libor as a function in our global economy.
This scandal will impact our investments in the future and certain assets will benefit greatly from this recent development (believe it or not). Never bring anger to your investing endeavours as it will only hinder your abilities to perform and retain important information.
The Wall Street Journal reported on Thursday, July 5th that:
More than $800 trillion in securities and loans are linked to the Libor, including $350 trillion in swaps and $10 trillion in loans.
To put this into perspective, the CIA’s World Factbook estimates the global economy – as measured by the world’s gross domestic product – is less than $80 trillion.
Investments and loans worth more than 10 times the entire world economy are pegged to the Libor rate. Your mortgage and car loan are directly influenced by it. Although it might not impact a regular joe more than a couple hundred bucks a year, for those borrowing billions, a slight Libor rate adjustment can create monstrous profits or losses.
Who Wins and Who Cares?
Who cares if Barclays or other huge banks manipulate the Libor rate, which is produced at 11 am each and every morning, by a fraction of a percent (which can allow the bank on the right end of the trade to make an extra $10 or $20 million)? Does it affect you? Does it really matter? The answer is unequivocally, yes it does. It matters a lot.
The notion that the Libor has been, or is manipulated, must be a well-known fact among the top global banks. These types of fiascos are what undermine the very integrity of our markets.
Anything that relies on the economy, or human control, has proved fatally flawed in recent years. If there was, in fact, collusion among some of the largest banks and central banks in the world to manipulate the Libor, then sadly, our financial system has been overthrown by a CARTEL. Any rope or slack given to influential market players is taken to the extreme for individual or institutional gain. Trust and stability are leaving the financial system and this is VERY dangerous.
The markets can only take so much abuse and manipulation. If this Libor scandal blows up and cartel-like behaviour is exposed, things could get ugly. Investors could flee the financial markets in droves. A gloomy forecast indeed. However, if mass amounts of capital leave the financial markets, due to corruption, where will it go?
Hard assets will be the benefactor. In fact, this recent scandal prompted famed investor, Jim Sinclair, to predict $3500 gold within 12-36 months. He stated “The change today is that the ‘Rig Is Up.’ The Bank of England turning their backs on Barclays, the company who did their bidding, will be the event in time marking the trend change.”
Standard & Poor’s and Moody’s, the world’s two largest credit ratings agencies, put Barclays on negative watch over the uncertainty created by the resignation of three senior executives due to the Libor scandal.
Barclays CEO, Mr Diamond, resigned on Tuesday under pressure from politicians and regulators. Jerry del Missier, Barclays COO, resigned after it surface that he “misunderstood” a conversation between Mr Diamond and Paul Tucker, the Deputy Governor of the Bank of England. He told staff that they had been instructed by the Bank to deliberately lie about their Libor submissions.
David Meister, the CFTC’s director of enforcement, stated that:
“The American public and our markets rely upon the integrity of benchmark interest rates like LIBOR and Euribor because they form the basis for hundreds of trillions of dollars of transactions and affect nearly every corner of the global economy.
Banks that contribute information to those benchmarks must do so honestly. When a bank acts in its own self-interest by attempting to manipulate these rates for profit, or by submitting false reports that result from senior management orders to lower submissions to guard the bank’s reputation, the integrity of benchmark interest rates is undermined. The CFTC launched this investigation to protect the markets and the public from such illegal conduct, and today’s action demonstrates that we will bring the full force of our authority to bear as we carry out that mission.”
If there is a way to monitor the real rate every member bank is providing at every moment, you’d hope it would be implemented to solve this problem and install some faith back into the system. Looking back on history, and considering the major players involved, common sense suggests this won’t happen.
The Fed Angle
The Federal Reserve answers to no one, but influences many. It has clearly influenced the Libor dramatically in recent years and we have the comparative interest rate numbers to show how closely the Fed’s line up with those of the Libor.
In June of 2012 the Libor one month rate was 0.2432, two month was 0.4656, three month was 0.7364 and one year rate was 1.0692.
Libor rates hit a record one month low of 0.1866 and one year low of 0.7269 in June and July of 2011. Deflation was such a threat during this period, that banks were willing to lend out money for basically nothing in return. This goes against nearly all risk management criteria, but nevertheless, it was done. The one year rate has been just over 1% since late 2011 and has remained just above that since then.
Review past Libor rates by clicking here (notice the dramatic and prolonged drop in rates over the past few years).
The whole game will go up in smoke if these rates rise. In many ways, the Libor is the master of the lending universe and the heartbeat of economic activity. Will this latest manipulation scandal provoke a global distrust in our financial system? Perhaps it won’t.
However, this market and our global financial system is getting dangerously close to losing what little trust and integrity it has left. Our markets and economies are too fragile as it is. If integrity is lost, investors will hit the door as they did in 2008 and another crisis style intervention will quickly be at our doorstep.
Trust is like a mirror…once its broken you can never look at it the same again…
All the best with your investments,