Your Saturday Morning Reading Assignment Is

This article from the Economist, which provides a handy and infuriating synopsis of the now burgeoning scandal concerning LIBOR, or the London Inter-Bank Offered Rate.

I cannot even begin to explain how big a problem this is -- the LIBOR rate serves as the underpinning for untold billions of financial transactions worldwide. The LIBOR number was pretty much sacrosanct when I worked for B of A and the LIBOR was a component of nearly every deal we did with our customers. From the article:

What may still seem to many to be a parochial affair involving Barclays, a 300-year-old British bank, rigging an obscure number, is beginning to assume global significance. The number that the traders were toying with determines the prices that people and corporations around the world pay for loans or receive for their savings. It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year. Yet it turns out to have been flawed.

Flawed isn't the right word for it. More:

In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten. First, it is based on banks’ estimates, rather than the actual prices at which banks have lent to or borrowed from one another. “There is no reporting of transactions, no one really knows what’s going on in the market,” says a former senior trader closely involved in setting LIBOR at a large bank. “You have this vast overhang of financial instruments that hang their own fixes off a rate that doesn’t actually exist.”

A second problem is that those involved in setting the rates have often had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. Worse still, transparency in the mechanism of setting rates may well have exacerbated the tendency to lie, rather than suppressed it. Banks that were weak would not have wanted to signal that fact widely in markets by submitting honest estimates of the high price they would have to pay to borrow, if they could borrow at all.

The term "swag number" is something I learned very early in my career. A swag number is a rough estimate that is used as a placeholder until you are able to determine the actual number that should be used in a formula. Generally a swag number is based on your knowledge of how things typically work, but should never be considered as reliable. If the reports are true, LIBOR was essentially a swag number, but with an added layer of duplicity baked in. This explains how it could "work" for so long even if its actual derivation weren't legitimate. You can base a lot of history and even an ostensibly plausible business plan on how things typically work, but in the end the numbers do come in and there has to be a reckoning.

Untangling this mess could be nearly impossible, since nearly every person who has taken out a loan or earned interest on any bank account has been touched by LIBOR. And there's at least some suggestion that the regulators who should have been policing the matter are complicit. From the article:

Confounding the issue is the question of whether Barclays had, or thought it had, the tacit support of both its regulator and the Bank of England (BoE). In notes taken by Mr Diamond, then the head of the investment-banking division of Barclays, of a call with Paul Tucker, then a senior official at the BoE, Mr Diamond recorded what was interpreted by some in the bank as a nudge and a wink from the central bank to fudge the numbers (see article). The next day the Barclays submissions to LIBOR were lower. This could be a crucial part of the bank’s defence.

Can you imagine this being the case? I certainly can. More:

The revelations also raise difficult questions for regulators. Mr Tucker’s involvement in the Barclays affair may harm his prospects of being appointed governor of the Bank of England, although he may well have a benign explanation for his comments (he is due to appear before parliament soon).

Another issue is the conflict central banks face, in times of systemic banking crises, between maintaining financial stability and allowing markets to operate transparently. Whether the BoE instructed Barclays to lower its submissions or not, regulators had a pretty clear motive for wanting lower LIBOR: British banks, in effect, were being shut out of the markets. The two hardest-hit banks, RBS and HBOS, were both far too big to fail, and higher LIBOR rates would have made the regulators’ job of supporting them more difficult.

This is worth remembering when you hear people claim that the answer is hiring more regulators. Regulators may be honest brokers or may not be. When I learn about things like this, I'm often reminded of the tragic wisdom from Jean Renoir's 1939 film "Rules of the Game," to wit:

The awful thing about life is this: Everyone has his reasons.

This is true. And while knowing that doesn't change anything, it's still worth learning the reasons. And that's why I'd recommend that you read the whole thing.