Streetwise Professor

April 18, 2008

Putting the Lie in LIBOR

Filed under: Derivatives,Economics — The Professor @ 10:24 am

Today’s Wall Street Journal reports that the LIBOR rate spiked up on the British Bankers’ Association’s announcement that it was accelerating its investigation of whether banks have been systematically misreporting the LIBOR rates they pay to acquire funds on the interbank market.

This reminds me of the effect of the release of the Christie-Schultz study showing that NASDAQ dealers did not quote odd-eighth spreads, and speculating that this may have reflected collusion among the dealers. The narrowing of spreads upon release of the study was damning evidence that something was indeed amiss. The banks’ raising their reported LIBOR rates is similarly suspicious. Haven’t these guys heard the old line: “That’s my story and I’m sticking to it?” Changing stories when the old one is questioned is tantamount to confession.

My prediction: this will result in a class action bonanza, and perhaps other individual lawsuits. The CME’s Eurodollar futures contract–the largest in the world–is settled against LIBOR. Systematic downward biased reporting of LIBOR rates post-credit crisis could have cost those short Eurodollar futures immense sums. Similarly, those short swaps would have received smaller cash flows if LIBOR rate rates were misreported. The OTC swap markets are immense, and even a few basis points of skewing of the LIBOR rate could cost those short swaps huge amounts of money.

When will these people ever learn? And does it take the prospect of huge legal costs to get them to clean up their acts?

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