Libor: The Big Fat Lie
Western financial markets are often characterised by a colossal failure of supervision, every few years. Whether it is the Savings & Loans scam in the 1980s, the insider trading scandal of the late-1980s, the accounting scandal post dot-com bust in early-2000 or the bursting of the housing bubble in the mid-2000, companies, traders and bankers have repeatedly gamed the system and made millions. The supervisory failure is so routine and regular that it does not shock people anymore. But fixing the London Interbank Offered Rate? Even for the world-weary, it was a shock.  
 
It all started on 16 April 2008 when The Wall Street Journal printed a story on its front page with the headline “Bankers Cast Doubt on Key Rate Amid Crisis”. Written by Carrick Mollenkamp from Fleet Street, London, it began: “One of the most important barometers of the world’s financial health could be sending false signals. In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit to, bankers and traders are expressing concerns that the London Interbank Offered Rate, known as Libor, is becoming unreliable.”
 
That was a serious understatement. Libor was actually being rigged with impunity. Libor is a benchmark of interest rates that the world’s leading banks charge each other for short-term loans. It was supposed to be ‘the world’s most important number’, to which more than $300 trillion of mortgages, loans and derivatives were pegged. And, yet, a close network of traders and brokers was manipulating this number on which a substantial part of the Western economy depended, before getting caught in 2012. Liam Vaughan and Gavin Finch’s The Fix tells us the story of this monumental scandal.
 
The most obvious question is: How was Libor getting manipulated? The starting point was the primitive way Libor was calculated. The rate was an average of different banks’ estimates of how much they thought they would have to pay for funding. As the authors write, the “big flaw in Libor was that it relied on banks to tell the truth but encouraged them to lie. When the 150 variants of the benchmark were released each day, the banks’ individual submissions were also published, giving the world a snapshot of their relative creditworthiness.” Those making their firm’s Libor submissions “were prevented from deviating too far from the truth because their fellow market participants knew what rates they were really being charged.” 
 
The central character in all this was Tim Hayes. Sometime in 2006, Hayes, a trader with UBS Securities based in Tokyo had figured out how to rig Libor. When he was a junior trader in London, Hayes “had got to know several of the 16 individuals responsible for making their bank’s daily submission for the Japanese yen.” He realised that these guys relied on inter-dealer brokers, the middlemen involved in all trades, on what rate to submit each day. “In the opaque, over-the-counter derivatives market, where there is no centralised exchange, brokers are at the epicentre of information flow. That puts them in a powerful position. Only they can get a picture of what all the banks are doing. While brokers had no official role in setting Libor, the rate-setters at the banks relied on them for information on where cash was trading.” 
 
Hayes cultivated them, bribed them to submit rates according to his market positions, which came especially handy for him in the crisis of 2008, when, incredibly, instead of the rate shooting up (due to the liquidity crisis), Libor indicated that it would fall. This helped Hayes survive the 2008 crisis as he offloaded his positions based on rigged rates. In 2009, Hayes left UBS and joined Citibank, lured away for a $3 million bonus by Chris Cecere. 
 
Among those who read the WSJ article on Libor was Vince McGonagle, working at the enforcement division of the Commodity Futures Trading Commission (CFTC) in Washington for 11 years. He asked his staff to put together a dossier and decided to launch an investigation. Earlier, in March, economists at the Bank for International Settlements, a group created by central banks around the world, had published a paper that identified unusual patterns in Libor during the crisis. However, the study concluded that these were “not caused by shortcomings in the design of the fixing mechanism.”
 
Sometime in the afternoon of 8 December 2009, Cecere felt that the six-month yen Libor was too high. When he checked the submissions from the previous day, he was surprised to see that Citigroup had put in one of the highest figures. “Cecere contacted the head of the risk treasury team in Tokyo, Stantley Tan, and asked him to find out who the yen-setter was and request that he lower his input by several basis points. It turned out the risk treasury desk in Canary Wharf was responsible for the bank’s Libor submissions,” write the authors. Tan spoke to the London office to consider moving the quotes lower. However, the risk management group in London didn’t budge. Cecere asked Tan to ask London again and was rebuffed by Andrew Thursfield, Citigroup’s risk head. Hayes tried to work his contacts in London but failed. Not only would Thursfield not oblige but, in March 2009, he gave a presentation via video link to investigators on the rate-setting process. Hayes tried to push harder and got reported by Citibank officials in London. After this, the scandal unravelled quickly, as CFTC closed its net and even the brokers stopped cooperating with Hayes. 
 
Finally, Deutsche Bank, UBS, Barclays and other banks paid up a fine of a few billion dollars and just one person went to jail: Tom Hayes, arrested in 2012 and convicted in 2015 for 14 years, which was reduced to 11. This is a compelling story of the Libor scandal told through Hayes, the obsessive high-risk trader, later diagnosed with Asperger’s disease, who bent the rules, bullied the brokers and bribed them to fix Libor to his advantage. The authors narrate the crime and one punishment in a factual manner, without getting into value judgement on whether others in the game deserved to be convicted as well.
 
Separately, it transpired that even foreign exchange rates were manipulated, between December 2007 and January 2013, in which traders in UBS, Bank of America, Citigroup, JP Morgan, Barclays and the Royal Bank of Scotland were involved. Later, six banks were fined $5.6 billion over this separate scam.
 
The book reads like a novel where characters, events and locations come alive with vivid descriptions. It opens with a secret meeting in a bar with a source, who identifies Hayes as the villain of Libor manipulation setting the tone of for a gripping thriller. But the real villains of the saga are British Bankers’ Association (BBA), Financial Services Authority (FSA), UK, and Bank of England (BoE). BBA continued to claim, long time after the WSJ article, that the Libor was reliable even in times of financial crisis. In October 2008, the International Monetary Fund found that “although the integrity of the U.S. dollar Libor-fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar Libor remains an accurate measure of a typical creditworthy bank's marginal cost of unsecured U.S. dollar term funding.” The minutes of the Bank of England show that deputy governor Paul Tucker was aware as early as in November 2007 of concerns that the Libor was being manipulated. In early 2008, the then New York Fed President Tim Geithner wrote to BoE chief Mervyn King to ‘fix’ Libor. But BoE didn’t act on it. FSA couldn’t care less about Libor. This is a short, fascinating book and a must-read. 
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    COMMENTS

    Mahesh S Bhatt

    2 years ago

    Good One Debashis God's Blessings to Moneylife & us.Stay Healthy & Blessed Mahesh Bhatt

    Mahesh S Bhatt

    2 years ago

    Money is Maya & Maya is sexy & its frauds are sexier.Man Made Money & Money made Man Mad.He Forg0t Dash Laxmi ( 10 types of wealth) described in Vedas & view Values for Wealth at kirticorp & youtube user kirtidabhatt web sites. This makes Sharad Pawar look dumb & so is FIFA scam which makes BCCI look dwarfs. We need to improve our standards of corruption as per Global levels.What a paradox World tells India is most corrupt country while numbers donot lie. Om Shanti Shanti Happpy Deepwali & New Year expect Values of Currency free fall as States are manipulating at economy/technology & even at Spiritual levels. Mahesh Bhatt

    How Lynch, Buffett and Others Invest
    There is a swathe of books on long-term investing. The most popular among these are about the value investing approach which remains rather undefined. One of the classical versions of the approach is to buy stocks available at a throwaway price (deep value investing). This has turned out to be a graveyard even for many accomplished investors, as they waited years for the elusive turnaround as the stock went lower and lower. Value investing now, often, means buying good-quality stocks at low prices, and, therefore, as an approach, is indistinguishable from any other sensible approach to buying stocks. After all, nobody would like to invest in buying expensive stocks of mediocre companies. There are many books which tell you how to picks stocks well. So, can another book add much value? Invest Like a Guru is, indeed, an important addition to the art and craft of stock-picking because it is evidence-based. Charlie Tian’s approach rests on two simple strategies.
     
    1. Buy Quality… 
    One of the first steps in value investing is identifying good companies to invest in because they reduce your worries about timing and are unlikely to inflict permanent loss of capital. How does one identify such companies? Warren Buffett said, “Time is a friend of the good business and an enemy of the mediocre.” Tian says “We should look at the financial statements of companies for at least one business cycle to see how the business has done during good times and bad. Of course, the requirement of at least one business cycle will exclude many companies that have short histories, or making new issues. Investors should avoid new companies that haven’t yet proven themselves.” This also means the Next New Thing. “Avoiding mistakes is more important for long-term investment performance.” To see if a company qualifies as a good company, investors need to ask themselves three fundamental questions while consulting the historical financial statements of companies:
     
    1. Is the company consistently profitable at good and stable profit margins, through good times and bad?
    2. Is this an asset-light business that has a high return on investment capital?
    3. Is the company continuously growing its revenue and earnings?
     
    Is this just another of those opinions that seems intuitively correct or are there hard facts to justify this? To show how relevant the hypothesis is, Tian identified the stocks (3,577) traded continuously over the past 10 years. “Among these 3,577 stocks, 1,045 or 29% were able to make money every year. Collectively, they averaged an annualised gain of 8.5% a year, doubling the gain of 4.2% generated by the second group, which were profitable in 9 out of 10 years. For the companies that were profitable six or fewer years over the past 10, the average gain is negative, even if held for 10 years.” Clearly, the possibility of losing money with any stock is greatly diminished for a company that is consistently profitable. 
     
    Of course, this study only records companies that were traded 10 years ago and are still traded today. This approach is statistically flawed because it is biased in favour of survivors which would be unknown at the start of the 10 years. But, in this case, the bias is in favour of companies that have been losing money. If those that continued to lose money and went bankrupt were included, the gains for the group companies that lost money would be even smaller and the percentage of the companies that lost money would be greater. 
     
    In short, by simply investing only in companies that are always profitable, investors can avoid losses and achieve above-average returns. But even if a company has always been profitable, that doesn’t mean it will continue to be so. How to guard against it? By focusing on a second metric: operating margin. “We want to invest in those that consistently have above-average profit margins. If a company can maintain a higher profit margin over the long term, it most likely has an economic moat that protects its pricing power from competition. A higher profit margin also leaves room for the business to stay profitable during bad times, when a low and unstable profit-margin business may fall into loss, which usually results in major punishment to its stock price,” writes Tian. 
     
    What kind of profit margin is high? Tian goes back to the database of 577 companies and shows the distribution of the operating margins. Many companies had an operating margin between 3%-8%. The median was 10%. Roughly 29% companies had an operating margin higher than 20%; 16% had a margin of 30% or higher; 12% had been profitable and had a 10-year median operating margin higher than 20% over the past 10 years. Applying the filter of consistent profitability with a 10-year operating margin of 20%, only 429, or 12%, companies in the US passed the filter. Interestingly, as long as a company was consistently profitable, the operating margin figure didn’t make much of a difference on its stock performance. “For the 1,045 companies that were consistently profitable over the past 10 years, there is no clear correlation between the average annualized gain of the stock and the median operating margin over the same 10-year period. But we still prefer those with higher margins because a lower profit margin leaves less room for error,” writes Tian.
     
    2. …At Fair Prices
    Wal-Mart stock gained more than 500% in three years, to around $70 a share by the end of 1999. It was a great company that easily met the criteria of being consistently profitable and with high margins. But had you bought Wal-Mart in late-1999, 12 years later, you would have still not made any money and 17 years later, barely enough. “Wal-Mart has quadrupled its earnings from 1999, but those who bought in 1999 have not benefited because they overpaid for the stock,” points out Tian. Wal-Mart had a P/E (price-to-earnings ratio) of 60 at the end of 1999. Today, the P/E ratio of the stock is 16. What the company gained in profit expansion, the market took away in value compression. 
     
     
    That brings us to the second part of Tian’s approach: find fair value for the stock. Tian, following the classical approach first elaborated by John Burr Williams in 1938, points out that the value of a company is the present worth of its stream of future earnings, called discounted cash flow (DCF). Unfortunately, this is elegant in theory but useless in practice. It asks us to estimate how much the company will make over the next, say, 10 years, the number of years of the business’s remaining life, and the appropriate discount rate. These are all shots in the dark. If it were not so, we would come across how the DCF calculated for this company or that has turned out to be stunningly accurate. These are, at best, estimates and may help brokerages to construct a future scenario that institutional investors can use to justify the purchase of a particular stock. The second approach of Tian is to calculate a fair P/E which was used by Peter Lynch and expressed as a rate that is below the growth rate. In other words, if a company is growing at 20%, the fair P/E of the stock is 20. Strangely, Tian tucks in a lot of very useful tips of how to use different valuation ratios (price to earnings, price to book value, price to sales and price to cash flows) as part of  a chapter called “How to Evaluate Companies”. 
     
    This is an excellent book, with clear advice on how to pick stocks. It also has a lot to say on failures, errors and traps. Unfortunately, as happens with every investment book barring just one or two, there is nothing on when to sell. Nevertheless, a good book to read.
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    User

    COMMENTS

    Abhijit Gosavi

    2 years ago

    And this article is *not* behind a paywall? Wow! Are you kidding me? :) Facepalm! Was debating with myself whether I should buy this book! Wow again though!

    Selective Memories
    It is raining books by bankers and former governors of the Reserve Bank of India (RBI). Quick on the heels of Duvvuri Subbarao’s book (Who Moved My Interest Rate. Leading the Reserve Bank through Five Turbulent Years), we have Yaga Venugopal Reddy’s Advice & Dissent: My Life In Public Service. Even before we digest this, the high-profile Dr Raghuram Rajan’s book (I Do What I Do), was...
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