Though Cowards Flinch

On Friday, Sunny had a decent go at explaining the LIBOR scandal to the swinish multitude.

Sunny make clear the key difference between the 2005-07 fixing (although it now looks like it started much earlier than that), when it was all about traders’ own positions and bonuses, and the post-crash phase when it became about top-down orders to fix LIBOR in the interest’s of the bank’s then–precarious overall state (we should remember it might have gone under but for those nice Qataris).  The only real interrelation of interest between these two phases of corruption is the great likelihood – strangely under-examined by MPs when Diamond came before them – that he and the Barclays top brass could only have known that LIBOR-fixing to shore up the bank’s credibility was an option, if they had known about the phase 1 LIBOR-fixing and how it was done.

But where Sunny gets it wrong is in his assessment of the impact of  the phase 1 (2005-07) scandal:

But there’s a key point to remember. When manipulating the rate, Barclays pretended to have a higher rate (making them more money) before the 2008 crash……It meant that before the crash Barclays ripped us off by charging a higher rate on financial products that went through their hands. That affected almost anything we borrowed, including 100% of sub-prime mortgages in the US.

It’s understandable that Sunny should have taken this line, since it was also the line take by housing minister Grant Shapps, and the polemicist in Sunny was keen to develop the ‘Even the Tories admit it’s bad’ narrative.  Unfortunately, this overlooks the fact that Shapps is a moron, keen enough to jump on the anti-Barclays bandwagon as it rolled through parliament as it rolled through parliament last week, but clearly ignorant of what had actually been going on with LIBOR rates.

The simple truth is that in the phase 1 corruption Barclays traders and submitters were in collusion (quite possibly along with other banks) to fix Libor at both higher and lower rates, not simpley at higher rates.   This is crystal clear from the Commodity Futures  Trading Commission report, which quotes emails from traders like this one (p.9):

“WE HAVE TO GET KICKED OUT OF THE FIXINGS TOMORROW!! We need a 4.17 fix in 1m (low fix) We need a 4.41 fix in 3m (high fix)” (November 22, 2005, Senior Trader in New York to Trader in London).

Traders fixed position in whichever way would best suit their side of the derivative deal(s) then in question, and it is therefore unlikely that this had any substantial direct impact on loan and mortgage rates.  Certainly there was no systematic fixing with the aim of ensuring higher loan rates; while that might have benefited Barclays profits overall, it would not have been reflected in traders’ own profit-making, and subsequent bonuses, and would therefore have been of no interest to them.  The most that might be said that, over the whole period LIBOR had more high fixes than it had low fixes.

This isn’t to say, though, that there were no ‘real world’ impacts. It’s just that we have to look for them in a different place.

Traders were fixing LIBOR in order to cheat on derivative deals via their access to “asymmetric information”.   That is they were selling (and buyong) financial products like interest rate financial futures, options, swaps or special bonds, which are supposed to offer institutional buyers protection against risk from interest rates volatility, which had become somewhat more marked in the 1970s and 1980s, but they were doing so with prior knowledge of what the LIBOR rate would be at any one point of time, with LIBOR used as a key reference point in the contract drawn up between the two parties.

The intricacies of how exactly this was done are far too complicated for me to understand, and probably always will be but one example of this might be the corrupt manipulation of the LIBOR rate to make more money from a capped floater trade, under which an institutional investor buys a floating rate set at a margin above LIBOR.  If the LIBOR rates then goes up, the bond price does not follow as it is ‘capped’.  The (corrupt) trader then sells on the bond to a firm that wants to manage interest rates in the interests of stable cashflow, but if he is able to ‘adjust’ the LIBOR benchmark operational at the time of the two deals he stands a good chance of making a better margin on the overall trading.*

Whatever the exact workings of the corruption, the important point is that we’re talking not about real assets but about deals which derive from those assets, and which end with traders effectively pocketing the profit on these trades at the expense of people who didn’t know that the trader in question was manipulating LIBOR.

But why should socialists care if it’s not about real assets?

Well, we should care because, where a trader is winning, someone else is losing.  That’s the nature of the deal. Yes, firms effectively pay a premium, via derivatives, to insure against interest rate risk, but they spend more than they might do if these premiums are fraudulently created in the first place.  And the institutions that have been systematically losing out are ones which actually count in the real world.

We know, for example, that a very high percentage of the top 500 companies regularly engage in derivative trading as a means to reduce risk (not just in interest rates, but including these), and while corporate profits might not be the biggest concern for socialists, I suspect most would rather have the profits with real world firms rather than in trader bonuses, if given just that choice; at least there is a chance of the corporates might at some point invest and creat jobs…….

However, it’s not only the big corporates who have potentially been losing out big time.   It’s also UK Pension Funds, as well as as big civil society institutions like the Church and philanthropic investors, who rely on fund/asset managers in the city to maximise their returns.  There seems little doubt that these fund managers (e.g. Cazenove, Blackrock) have not been in the know about the LIBOR-fixing – just listen to the ‘astonished’ reaction of one of them to what’s been going on and you’ll get a sense of how keen they will be to play the victim on this scandal.

And the hit on these institutions looks very real.  Here, for example, is the reaction from the Investment & Pensions Europe magazine (registration required, but free):

Barclay’s attempts to manipulate the LIBOR rate between 2005 and 2009 could affect UK pension funds “negatively”, depending on their derivatives trades, but it is still too early to assess the full impact of the scandal, a number of consultants have said.

Following Barclays recent admission that it deliberately attempted to fix the rates over a five-year period, many in the industry have speculated whether pension funds’ returns were affected through commercial mortgages, swaps, short-term bonds and Barclays shares themselves.

But Boris Mikhailov, principal within Mercer’s financial strategy group, told IPE it remained unclear what impact attempts to manipulate the bank-lending rate had had on the published LIBOR rate itself.

“We need to wait and see if the published LIBOR rate should have been lower or higher,” he said.

According to Mikhailov, the real impact for pension funds will depend on their asset mix and derivatives positions at the time when the misconduct took place.

“Assuming that any manipulation did artificially lower LIBOR, then the implications for pension funds might be found on LIBOR obligations for the interest rate swaps or total return swaps they entered into,” he said.  “In that case, a pension scheme could potentially be impacted in the sense that it would have paid less than it should have done.

“However, there might have been a knock-on impact to the long positions under these derivatives. In other words, the fixed rate locked-in could have been lower too.”

The National Association of Pension Funds is already calling on its members to “discuss the potential impact with asset managers managing holdings on their behalf.”

Essentially, then, while the LIBOR corruption is perhaps unlikely to have has a massive direct impact on loans and mortgages, it could turn out that it has had a massive impact on something that matter equally to ordinary people – the value of their pensions – and that’s before we even consider the important role Pension Funds play in keeping our government debt domestically focused, and the role they might play in funding infrastructural development as a way out of the economic slump.

As Sunny says, yes, we sh0uld be angry, but for somewhat different reasons from the ones he suggests.

* For those wanting to get to grips with derivatives and risk management, by far the best summary for the lay reader that I’ve seen is the 12 page Chapter 13 of Philip Coggan’s The Money Machine: How the City works, from which this example is more or less nicked.