On June 27, 2012, Gary Gensler – head of a lesser known U.S. financial regulatory agency known as the Commodities Futures Trading Commission – made what will almost certainly go down as the most important announcement of his career. Investigators from the agency's Enforcement bureau had discovered reams of internal emails between traders at Britain's second largest bank, Barclay's, proving that for at least five years – from 2005 through 2009 – traders in the bank's swaps and derivatives units had been fudging submissions to the London interbank offered rate, also known as Libor – and it's European equivalent, Euribor – to increase the profitability of their trading positions.

The CFTC had been investigating Libor manipulation since 2008 and now it had its smoking gun. Barclays was fined more than $450 million for manipulating the rate – including the largest civil fine in CFTC history – and Gensler suddenly became a household name (at least in those homes occupied by business writers and financial regulatory officials). 

In an interview with Time magazine at the beginning of July, Gensler offered a simple summary of the developing scandal.

“We need an honest system and this was one bank that was trying to do something dishonest,” he said.
 
But before long it became obvious that the CFTC had stumbled on to something much bigger. Since the Libor scandal first broke, it has widened to comprise as many as 20 banks, including Citigroup, J.P. Morgan Chase and Bank of America – the three American institutions on the Libor rate-setting panel. Investigations have been launched against traders at Deutsche Bank, HSBC Holdings, Societe Generale and Credit Agricole, and court documents released in September tell of a Libor rigging “cartel” inside Royal Bank of Scotland's Singapore office. (At press time RBS was in settlement talks with regulators, and the European Parliament was threatening jail time for traders found guilty of manipulating the rate).

Officials are now looking into allegations of inter-bank collusion to artificially set Libor numbers that threaten to ensnare officials at the Bank of England and may lead all the way to the Federal Reserve and the European Central Bank.

Analysts say that when the dust settles, the Libor scandal will wind up being “the biggest consumer fraud in history,” amounting to more than $100 billion in legal liabilities. But it isn't just consumers who are feeling the pain. Billions of dollars in commercial loans are at least tangentially tied to the rate; and in these cases the cost of the scandal will be difficult if not impossible to ever fully gauge.
 
The Rise of Libor

Libor has been called “the world's most important number” but before the 1990s almost no one had ever heard of it. The index began its life in 1986, under the auspices of the British Bankers' Association, and has since become the primary metric for trillions of dollars of variable-rate loans – ranging from mortgages to equipment leases. Each day a panel of 18 financial institutions submit estimates of the rate at which they could borrow funds on the London interbank market. Quotes are issued in 15 different maturities ranging from overnight to one year – with the most common maturities being 30, 60 and 90 days.

Michael Kraten – an expert on interest rates who published an academic paper exposing irregularities in Libor back in 2008 – says the nature of the rate-setting process itself is largely to blame for the scandal.

“[Libor] is set by a cluster of banks that can profit by manipulating it. So, if you're a bank that earns money or loses money based on what an interest rate is and you have the ability to manipulate your own rate, you have the ability to manipulate the system to generate more profit for yourself,” he said. “And to the extent that such a system was completely unaudited and fairly unregulated it gave them the opportunity to take advantage of the rate-setting process, which they did.”

Because of its connection to complex securities such a derivatives, it's difficult to determine exactly how much money is tied to Libor. Most analysts agree it is responsible for the pricing of at least $350 trillion worth of loans and securities, while others say the total exceeds $500 trillion. But it hardly matters; the rate at which Libor is set determines the daily market value of millions of individual loans – including most of those booked by the U.S. commercial finance sector – and its accuracy is critical to borrowers and lenders of all shapes and sizes.

According to Michael Carsella, managing director of the middle-market advisory firm Previsio Partners and the former in-house counsel at LaSalle Business Credit, U.S. banks began their gradual transition to Libor in the 1990s because – unlike the Prime Rate, which was widely used prior to that period – Libor is less politicized, changes daily and is (in theory) tagged to market conditions. Carsella says middle-market commercial lenders were next to adopt the rate, as banks began pricing more deals tied to Libor options. He says it was a shift made out of necessity rather than choice.

“Big securitizations and corporate loans were all being priced using Libor, and this trickled down into the middle market,” he said. “Most people are of the opinion that [lenders] were dragged kicking and screaming to use Libor because their customers were getting a little more sophisticated and asset-based lenders were moving more upstream and getting into bigger deals.”

These early misgivings eventually abated as more and more lenders tagged their loans to Libor. In the long run the rate proved especially useful to financiers – like independent asset-based lenders and leasing companies – that rely on commercial paper instead of consumer deposits to fund their transactions. Today, while there is no independent tally on the dollar amount of outstanding U.S. commercial loans tied to Libor, the number is almost certainly in the hundreds of millions.

The Handwriting on the Wall

The Libor scandal may have caught the financial community off guard, but it didn't just materialize like a hurricane out of thin air. Carsella began exposing irregularities with Libor in the summer of 2009, in a pair of articles for the Commercial Finance Association's publication, The Secured Lender.

Among the evidence he noted was a widening split between Libor and the Federal Funds Targeted Rate; a year earlier, financial analysts noticed that the spread between 1-Month Libor and the FFTR had grown by a factor of more than ten, an unusual and troubling anomaly. In May of 2008, The Wall Street Journal published a report that found at least five banks – Citigroup Inc., WestLB, HBOS PLC, J.P. Morgan Chase and UBS – were reporting irregularly low Libor rates. The paper stopped short of accusing the banks of outright manipulation, but the story prompted the BBA to accelerate a review of the rate-setting process.

“This is about the need to ensure the integrity of Libor is absolutely right,” said Angela Knight, then-chief executive of the BBA.

The association went on to downplay the implications of the discrepancies, but when it completed its report in December 2008 it pledged to enhance governance and scrutiny procedures over rate data.

Around that time, Kraten joined a small group of academics and a Moody's analyst named Albert Metz in releasing a paper titled, simply “LIBOR Manipulation?” which showed that the process of self-reporting was flawed and could allow individual banks to manipulate the key global interest rate. He says that while it was impossible to know at the time the extent of the bank's complicity, it was clear there was something odd going on.

“If you cut through, and even push aside the very advanced and sometimes obscure statistical analyses, and just look at the quotes on a daily basis, and how they changed over time or never budged over time, you can tell that, whether or not it was an absolute conspiracy,” Kraten said.

For four years the report barely raised an eyebrow outside of academic circles, but when news of the CFTC fine against Barclays broke over the summer, Kraten was propelled into the media spotlight, garnering mentions in the Economist, Bloomberg Businessweek and the Financial Times. In August his research was cited on the floor of Parliament. 

“It's very seldom that a researcher like me starts working on something and four years later suddenly everyone starts to pay attention,” he said, bemusedly.

But Carsella notes that even with all the red flags, no one would have wagered that banks were intentionally tweaking Libor for profit.

“When I first wrote about this the concern was that banks, just to maintain their viability and their credit integrity in the markets, would fudge the rate so that they weren't perceived as having any financial problems,” he said. “That's totally different from what was exposed this spring and early summer, which involved much more sinister motivations.”

The Fallout

The Libor scandal has been called “the new asbestos” and “the banking industry's tobacco moment” – references to major corporate liability cases of the past – and it is expected to spark, in the words of Karen Shaw Petrou, managing partner of Federal Financial Analytics, “a waterfall of derivative lawsuits.”

John Coates, a law professor at Harvard, told Bloomberg that [litigation on Libor related matters] “has the potential to be the biggest single set of cases coming out of the financial crisis.”

“Libor is built into so many transactions, and Libor is so central to so many contracts. It’s like saying reports about the inflation rate were wrong,” he said.
 
But untangling the Libor mess won't be easy, and determining who stands to lose and by how much depends on a lot of variables. If Libor was set too high, loans may have been priced at rates exceeding true market value. In cases where banks lowballed their Libor rates, it's possible that borrowers got better deals than they should have.

According to Carsella, the companies that are going to have the most successful claims will be investors who were on the other side of those transactions and the reduced rate gave them a yield that was much lower than what they should have gotten. As for commercial lenders, the extent of the fallout could range from great to negligible depending on how a company sources its funds.

“If you're a GE and you're out in the marketplace every day and you're basically funding GE Capital through the commercial paper market you're very much tied to Libor,” Carsella explained. “But if you're a Wells Fargo, or a Bank of America with a huge deposit base, your cost of funds is really not as heavily dependent [on Libor].”

But Kraten says even firms that can prove they were hurt by Libor manipulation may find recourse elusive thanks to the arbitrary nature of the index.

“It's one thing for a regulator to step in and say there are regulatory penalties or even criminal penalties, [but] in civil court, if you want to win a case you need to do a pretty good job of quantifying the damages,” he said. “The problem with the Libor process is the way in which the original bank bids were defined were so fuzzy to begin with that it's very difficult to define what the original bids that created the Libor rate should have been if they were properly executed.”

At the end of September, Britain's Financial Services Authority unveiled a long-anticipated review of Libor that proposed sweeping reforms to the rate, but stopped short of scrapping it altogether. The agency delivered a ten-point plan that includes independent oversight by a newly established panel starting next year, stricter guidelines for rate setting, and new penalties for banks that stray from the path. As a result of the reforms, the BBA will no longer have a role in setting Libor. The changes were met with muted applause by many in the financial community, but even with the patchwork of fixes, the consensus is that the credibility of Libor has suffered a critical and potentially irreversible blow.

When all is said and done, however, that may not matter much. A poll conducted at the end of September by Thomson Reuters found that while a majority of corporate borrowers consider the rate potentially inaccurate, few plan to stop using it. It seems that for the time being at least, Libor and the complex issues that accompany it are here to stay.