A Scandal far Worse than Subprime Mortgages

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani

Most of us know about the subprime mortgage scandal. In the years preceding the financial crisis, banks sold high interest rate mortgages to individuals who could never afford to repay those loans. Considerable profit was made by banks in the process, and it ultimately led to the financial crisis and global economic slowdown.

Recently, a new allegation of corrupt behavior at investment banks has emerged. It is regarding manipulation of the London Interbank Offered Rate (LIBOR). LIBOR is a daily interest rate that is meant to reflect the cost of borrowing for large banks between one another. It is also used heavily in derivative transactions, and many of the interest rates we see as consumers are indirectly influenced by LIBOR.

The derivative transactions that involve LIBOR are essentially securities that institutional investors can use to bet on which way LIBOR is going to go. The banks sell these securities to investors, and investors make a profit if LIBOR goes in their favor and a loss if it goes against them. A lot of the time, institutional investors use these derivatives to hedge against their own exposure to interest rates.

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The scandal that has emerged is that banks were colluding to set the LIBOR rates, and then selling derivative products to investors to bet on which way LIBOR would move. Since the contracts were between the bank and the investor, one party's loss was another party's gain. And so they convinced investors to bet on LIBOR moving in a certain direction, and then themselves set LIBOR rates to go in the other direction. As a result, banks made a large profit at the expense of the investors.

A good analogy to understand what is going on is to imagine that there is a cricket match between team A and team B. I am a bookie and convince you to bet on team A because I tell you that they are most likely to win. At the same time, I go and fix the match so that team B wins. In the end, I collect your money.

This is exactly what has occurred with the LIBOR scandal. Banks rigged the game so that only they could win. The LIBOR scandal has not been in the press as much as the subprime mortgage scandal mainly because it does not directly affect consumers or retail investors. But indirectly it does.

Many of the investors who lost out include pension funds and governments, whose losses will eventually become our losses. As of now, certain investment banks are under investigation as to the extent of their involvement in this scandal. Hopefully regulators will have the sense to inflict penalty in proportion to the crime, and prevent a reoccurrence.