Lie-bor: Could the Biggest Scam in History Maybe Destroy Wall Street?

It’s sort of sad that the biggest banking scandal ever, one that makes that whole Madoff deal seem downright amateurish, feels so utterly predictable. We now know that Barclays, along with other major global banks, have been rigging the calculation of Libor, the most integral financial number in the world.

Libor is the primary benchmark for the world’s short term interest rates. Calculated every day for ten currencies, it’s used to determine the borrowing costs for trillions of dollars in loans. Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to Libor; by some estimates, the total number of assets in the world pinned to the Libor rate is around $800 trillion, over eleven times the size of the world GDP. "This dwarfs by order of magnitude any financial scam in the history of markets," says Andrew Lo, a professor of finance at MIT.

It gets worse. Not only was this the biggest scam ever, orchestrated by a cartel of the world’s banks, but it looks like the authorities – the ones who are supposed to protect us from things like this – were in on it too, or at least aware that such shenanigans were pervasive. The rate fixing wasn’t just an open secret on Wall Street, but it was also on the radars of officials at the Bank of England and the Federal Reserve, according to a new report from Reuters.

How much did the Fed know and what could they have done about it? This chart shows that the Fed did everything within its power to keep Libor down once the crisis began. In the finance world, that generally means a toolbox of acronyms: TARP, TALF, QE1 — all of which are mechanisms to extend credit and expand money supply, or in other words, “print” money.

So what is Libor exactly? It's the London interbank offered rate, the average rate at which the biggest banks — guys like JPMorgan Chase, Bank of America and Citigroup — are borrowing from each other and quite possibly the most important single number in the entire financial world. When you go to the bank and apply for a mortgage, the rate you’re getting is most likely tied to Libor. Banks will ask a borrower to pay Libor plus a bit more, an added amount of interest that reflects the borrower's credit risk.

For instance, if Libor is at 5 percent, the bank might charge you Libor + one percent, or a six percent rate on your mortgage. If you get a fixed rate mortgage, this calculation happens once, when you get your loan. If you're on an adjustable rate mortgage, your bank might re-calculate against Libor regularly, affecting your monthly payment. For some loans, this re-calculation happens daily.

But this wasn't just about mortgages. Student loans (a trillion dollar market), credit card accounts (another almost trillion dollar market), really an endless assortment of financial instruments move in lockstep with changes in Libor, which is what makes this whole scheme so outrageously sinister. This was a con that touched just about every corner of the world from people and institutions to cities and countries.

"This is the world's biggest banks stealing money that would otherwise have gone toward textbooks and medicine and housing for ordinary Americans, and turning the cash into sports cars and bonuses for the already rich. It's the equivalent of robbing a charity or a church fund to pay for lap dances," Rolling Stone's Matt Taibbi wrote in June.

Banks were able to easily manipulate the number through collusion based on the way Libor is setup. It would be reasonable to assume that a benchmark of such international economic significance would have a scientific process, because it could, and should. Instead, the British Bankers Association, which oversees Libor, takes best-guess estimates from over a dozen banks on what they expect their borrowing costs to be. Libor is calculated daily by Thomson Reuters from the average after the outliers are dropped. Essentially rough numbers were accepted in blind faith.

But since these are estimates, no one is looking at what’s really happening. No one knows the truth. "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."

Such a system might work in theory, if every participant is trying their utmost best to produce honest numbers, but by the very nature of the system, the incentives to cheat and lie are tremendous. Whether or not a bank might lose or make money on any given day could depend on whether or not Libor went up or down. And given the reporting methodology, it wouldn't be in a struggling bank's best interest to give up their hand and announce to their rivals that they were weak (by showing a higher borrowing rate).

When a system has zero credibility, it’s only a matter of time before fudging numbers becomes the new norm, a culture that a writer at the Economist so pitch perfectly describes:

The most memorable incidents in earth-changing events are sometimes the most banal. In the rapidly spreading scandal of LIBOR (the London inter-bank offered rate) it is the very everydayness with which bank traders set about manipulating the most important figure in finance. They joked, or offered small favours. "Coffees will be coming your way," promised one trader in exchange for a fiddled number. "Dude. I owe you big time!… I'm opening a bottle of Bollinger," wrote another. One trader posted diary notes to himself so that he wouldn't forget to fiddle the numbers the next week. "Ask for High 6M Fix," he entered in his calendar, as he might have put "Buy milk".

And this is the central premise of the current financial narrative: criminal nonchalance, where cheating, lying or stealing isn’t just done in secret, but practiced openly, totally accepted and richly rewarded, with what I’m sure was really expensive coffee. Can we blame the people? (Barclays CEO Bob Diamond was the first casualty) Or should we focus on the systems that promote this kind of behavior, created from three decades of regulatory liberalization?

It’s not that we didn’t want to trust the banks. They’ve simply proven once again that they can’t be trusted — at least not without proper supervision. Could this be the banking industry’s “tobacco moment,” like some are suggesting? Or is this merely the tip of the iceberg? Because maybe what is truly nefarious about all of this is not that some banks were cheating for profits (that’s kind of a given), but that the entire system may have been gamed in order to cover-up just how broken it really was — and potentially still is.

In the meantime though, bring on the lawsuits.

Follow Alec on Twitter: @sfnuop