Tag Archives: Public trust

Libor: Are There Any Winners?

You didn’t really think that supporters of the global banking industry would simply surrender to public condemnation regarding the Libor manipulation scandal … did you?

Two weeks ago, we described why the scandal posed a threat to the public interest. And last week, we discussed the difficulties that plaintiffs may face when filing lawsuits to recover their losses.

This week, we end our first-ever trilogy of blog columns by exploring a recent counter-argument that is gaining traction among supporters of the global banks. Namely, some industry veterans are asserting that the scandal did little to harm borrowers …

… and may have actually helped them!

Interest Payments

The essence of their argument appears to focus on the direction in which the bankers at Barclay’s appear to have manipulated the Libor interest rate. Namely, they appear to have understated their rate quotes, as other banks purportedly did as well during the depths of the financial crisis in order to maintain the impression that they were strong and stable institutions.

The Washington Post recently quoted several industry experts who asserted that, by understating interest rates, the banks actually assisted borrowers by minimizing their interest payments. And Bloomberg quoted a representative of British mortgage lenders who claimed that “it’s very unlikely that Libor-fixing will have had any material impact at all on consumers … if anything, a downward impact on Libor (was) advantageous overall to the wider influence on rates …”

From a narrow perspective, this argument is indeed true. Borrowers with fixed rate loans, for instance, would not be affected at all by Libor rate manipulations. And borrowers with variable Libor-based loans would indeed enjoy reduced payments when the rate is manipulated downwards.

But from a broader perspective, would these conclusions remain valid?

Interest Rate Swaps

Let’s consider an example of a debt arrangement that is far more complex than a single variable rate residential home mortgage. Let’s ponder the plight of a municipal government entity, for instance, that agrees to a primary fixed rate debt instrument with a secondary variable interest rate swap.

Huh? How would such a transaction work?

Well, the borrower would pay a fixed interest rate on its primary debt outstanding, and then would purchase an exotic secondary derivative that would provide varying levels of reimbursement in proportion to fluctuations in market interest rates. The two opposing cash flows, when netted together, would be designed to generate net interest payments that would reflect changes in the variable Libor rate.

Unfortunately, though, this strategy backfired for many government borrowers (as well as for investors in debt instruments) when Libor rates declined, purportedly as a result of understatement manipulations. Such declines minimized the variable cash inflows received on the derivative transactions, but did not affect the cash outflows paid on the primary fixed rate obligations. That is why the City of Baltimore, the New Britain Firefighters’ and Police Benefit Fund, the California Public Employees Retirement System, and others are now contemplating legal actions.


There is also a macro-economic perspective that should be considered when assessing whether any borrowers have benefitted from the Libor scandal. To consider this perspective, let’s assume that the global banks were indeed fixing variable rates at inappropriately low levels.

Because other lenders “peg” their variable rate loans to Libor as well, they would have also received lower interest payments from borrowers. In other words, the revenue streams of relatively small competitors would have been damaged as severely as those of the global banks by such manipulations.

But which institutions may have benefited from revenue declines that affected global banks and smaller competitors simultaneously? The global banks, by nature of their sheer market size, their implicit (or explicit) access to bailout programs like TARP, and their thicker capital cushions, undoubtedly would have been better positioned to survive such circumstances.

In other words, like any dominant industry player that launches a price war with the intention of driving smaller competitors out of business, the global banks may have enjoyed a macro-economic advantage by forcing market interest rates lower. In the long run, the elimination of competition cannot be beneficial for consumers.

The Public Trust

There is one final perspective, perhaps the broadest one of all, to consider when assessing whether any borrowers actually benefitted from the Libor manipulations. Namely, can any member of society ever benefit, in the long term, from scandals that fundamentally damage the public trust in our global financial system?

If public cynicism about the system permanently depresses demand for variable rate loans in the United States, for instance, can any one truly benefit? Likewise, if citizens in Greece and other struggling European nations rebel in disgust against the austerity measures that are needed to repay the government debts held by global banks, can the system ever heal?

In the broadest sense, it is difficult to argue that any deceitful manipulation scheme can create “winners” among borrowers. In the long run, if there is no public trust in the global financial system, we are all inevitably “losers.”

Wall Street And The Public Trust

Three weeks ago, JP Morgan announced that it lost $2 billion on a single hedging position. Then, one week later, the firm released information that suggested that the transaction might have been more of a reckless gamble than a conservative hedge.

And last week, the financial community was even more concerned about Facebook’s botched Initial Public Offering (IPO) than about JP Morgan. Bloomberg named it the worst IPO of the decade; others speculated that it might be the worst IPO ever.

Government officials are now investigating the JP Morgan and Facebook transactions. Indeed, they may discover that the public trust has been badly damaged, whether or not there were any legal transgressions.

We’re In The Money!

In the Depression era film Gold Diggers of 1933, Ginger Rogers zinged Wall Street with the sardonic anthem We’re In The Money! While that film played on screens across America, President Franklin Roosevelt busily signed laws to ensure that another Wall Street crash (like the debacle of 1929) would never occur again.

The Glass Steagall provisions of the Banking Act of 1933, for instance, banned commercial banks from engaging in many proprietary trading activities. And the Securities Act of 1933 prohibited publicly traded firms from “playing favorites” by requiring them to disclose relevant information to all parties simultaneously.

These regulations were designed to protect the interests of small investors. Thus, banks that accepted savings and checking deposits were prohibited from putting those funds at risk, and from selectively sharing insider information with wealthy investors.

Such regulations became bedrock principles that generated a level of trust in the American financial system that helped the United States maintain its pre-eminent position in global finance for decades. Last week, however, JP Morgan and Facebook did much to damage the public trust in the system.

Hedging Activities

JP Morgan’s black eye involved what CEO Jamie Dimon initially called a “terrible, egregious mistake.” He originally claimed that the recent $2 billion loss resulted from a poorly designed hedging contract that should have shielded the firm from incurring losses, but that inadvertently generated mammoth losses instead.

The Volcker Rule of the Dodd Frank Act is designed to reimpose certain Glass Steagall policies that prohibit banks from engaging in speculative profit-seeking proprietary trades. But the Volcker Rule doesn’t prohibit hedging transactions, which are defensive strategies that are designed to function as insurance policies by limiting trading losses.

Hedging positions are desirable activities, from the perspective of government regulators, because — when designed and executed properly — they minimize the risk of losses. But two weeks ago, we learned that the division that designs JP Morgan’s hedging contracts may have been striving to generate significant profits instead of (or in addition to) focusing on minimizing losses.

A hedging function that attempts to generate sizable profits? Under traditional banking guidelines, it shouldn’t be considered a hedging function at all. And yet JP Morgan decided to define it in this manner, which arguably allows it to continue to engage in proprietary trading activities.

Valuation Disclosures

Meanwhile, last week, the first day of public trading for Facebook got off to a bumpy start. The NASDAQ experienced technical problems and was forced to delay trading activities for approximately 30 minutes.

After that, Facebook’s embarrassment grew worse. The value of Facebook’s stock began the day at $38, an amount established by the firm and its IPO advisor Morgan Stanley, and ended the day at virtually the same level. But it reportedly only remained at that level because Morgan Stanley and its team of underwriters bought back the stock to prevent it from dropping below $38.

By the end of the week, Facebook’s stock was trading at $31.91, 16% below its initial $38 value. Clearly, the firms established an initial value that was too high. But did Facebook and Morgan Stanley simply make a mistake by asking investors to pay an inflated value? Or were they — in the words of former General Electric CEO Jack Welch, according to his Twitter posting on May 21st — “piggish”?

Furthermore, we recently learned that Morgan Stanley warned its major clients in advance that it had reduced its revenue estimates for Facebook. Thus, preferred clients were warned that the opening valuation might be too high, but the general public did not receive this information.

Although the Securities Act requires firms to disclose relevant information to the general public, Morgan Stanley decided to define its warning as “guidance” and not as “disclosure,” which arguably allows it to engage in selective communication activities.

An Issue of Trust

It is indeed possible that JP Morgan, Facebook, and Morgan Stanley may have complied with government regulations. If they have not broken any laws, they will certainly not be prosecuted for breaching the public trust.

Yet public trust in the American financial system may well be damaged if JP Morgan’s trading activities are permitted to be defined as hedging transactions, and if Facebook’s and Morgan Stanley’s selective disclosures are permitted to be defined as guidance. And without the public trust, the financial system cannot endure.