This week's numbers: $453 million; $800 trillion; $31 million; 20; 150

$453 million... is a chastened number. That’s how much Barclays agreed to pay U.S. and British regulators for manipulating LIBOR. If the mortgage settlement was any indication, they’ll make up that money in no time by manipulating LIBOR.

$800 trillion... is a mammoth number. That’s the total value of the loans and securities linked to LIBOR – over 10 times the combined GDP of every nation on Earth. With all that imaginary money, they couldn't resist creating imaginary interest rates.

$31 million... is a sacrificial number. That’s how much in bonuses ex-Barclays CEO Bob Diamond gave up when he resigned. He still settled for $2 million and the knowledge that most people would confuse him with the head of JPMorgan anyway.

20... is a scandalized number. That’s how many big banks have been named in cases related to LIBOR so far. Maybe they figured there was no real harm if they all broke the law together, like drivers deciding they'd like to try out the wrong side of the road.

150... is a complex number. That’s how many LIBORs are published daily, including 10 different currencies and 15 different time-scales. Manipulating it must have seemed like the perfect crime: one only a very bored nerd could fully comprehend. 

If we can't rely on the accuracy of basic measurements used to set loan prices, we can't respond effectively to brewing financial crises.

Matt Taibbi asks why nobody is freaking out about the LIBOR scandal, Robert Reich calls it the scandal of all scandals, and Dylan Matthews has a great explainer of the whole thing here. Abigail Field has more at Reality Check.

This can be confusing stuff, so I want to go through a very simple example of how this impacts the markets. Here's a basic equation for the price of a loan:

The rate of a loan consists of adding the "risk-free" rate to a risk-premium. If either the risk-free rate or risk-premium goes up, then the price of a loan goes up. If you are a particularly risky borrower, you will pay more for a loan. This is because your risk-premium, compared to other borrowers, is higher, and that is added into your loan rate. If the risk-free rate is 3 percent and your risk of not paying back a mortgage requires a 2 percent premium, then your mortgage rate is 5 percent. If your risk of not paying back unsecured debt on a credit card requires an 8 percent premium, then your interest rate on your credit card is 11 percent.

More complicated models include more types of risk-premia and other things, but this basic approach is how financial markets work. They all need a measure of what money costs independent of the risks associated with any specific loan. As a result, all the most complicated models have this "risk-free" rate at their core.

Now think of some of the scandals and controversies over recent loan pricing. Here's a great Washington Post piece by Ylan Mui on African American homeowners scarred by the subprime implosion. There are cases where people with the same risk profiles were given different interest rates. Here's a report from EPI by Algernon Austin arguing that African Americans and Latinos with the same credit risks as whites were charged a higher total interest rate for mortgages even though the risk-free rate and their risk-premium rate should have been the same. The data implies that an additional, illegitimate "+ race" was added to the equation above.

There's also debates about what is appropriate to add to the risk-premium equation. The FTC alleged that credit card companies were using charges for marriage counseling or massage parlors to increase the risk-premium, and thus the total rate. Some would argue that, from the credit risk modeling point-of-view, these are appropriate measures to hedge against divorce; others would say that it looks like a cheap excuse to jack up the total rate using the risk-premium part of the equation as an excuse.

But those issues focus on how to price risk and what the total rate should look like. Running underneath all of these loans is what the "risk-free" rate should be. And by manipulating that rate, which forms the core of any financial model of how to price a loan, you manipulate every loan. Digging through some old financial engineering textbooks, it's amusing how many mathematical cartwheels are done to try and get an edge on the movement of LIBOR. Sadly. one can't model the dynamic of making an internal phone call and asking to please manipulate the numbers.

Now let's build out from a very simple model of a financial instrument to one of the more complicated ones -- the Black-Scholes PDE for pricing options and derivatives:

There's a lot of stuff going on in this equation which you can learn about here. But there's one variable you should catch. That "r" in the equation is the risk-free rate, which is usually LIBOR. One of the things Black-Scholes does is create a framework for understanding options and derivatives as owning pieces of the underlying object along with some cash, and getting the price of a derivative by understanding what it would mean to manipulate those two items. The cash in this framework, a crucial part, has its value determined by LIBOR. Which, as many are pointing out, implicates the gigantic derivatives market in this scandal.

Implicating the derivatives market makes it clear why this matters to the market. But what about the role this scandal played in the financial crisis? This brings me to part of Karl Smith's argument for why this scandal doesn't matter much. On Up with Chris Hayes he argued that both parts of the allegations shouldn't get us too upset, and in particular that the second allegation, that Barclays systemically manipulated its LIBOR rates downward (perhaps with the approval of regulators) to make it seem like it was healthier than it was, is a good thing. Why? Because it made the financial system seem healthier than it was, which was important to prevent a collapse.

In two follow-up posts (I, II) Smith clarifies his response. Smith argues that since the central banks were facing a financial crisis of epic proportions, one that would hurt many people, banks manipulating LIBOR helped keep that crisis at bay, which is a great thing. I think Smith has a theory I'm not following in which the only problem the banks had in 2008 was insufficient monetary policy, and not the fact that these banks were sitting on hundreds of billions of dollars in toxic loans that were causing a repo market bank run combined with an opaque over-the-counter derivatives system designed to induce counterparty risk in a crisis.

But the reason it matters is because that tactic can't work forever. You can manipulate prices and juke government stress tests and otherwise lie to make people believe your bank's balance-sheet is healthier than it is, but eventually that system is going to collapse. And, crucially, if the primary objective is "delay," then when the crisis actually hits, it hits in an overwhelming way with no plausible way to fairly allocate losses or take other actions.

As a side-note, if Smith agrees with manipulating LIBOR to look healthier, then he must really support the actions the Federal Reserve Bank of New York was taking in March 2008 to juke Lehman Brother's stress tests: "The FRBNY developed two new stress scenarios: 'Bear Stearns' and 'Bear Stearns Light.' Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed." Thank god that prevented an out-of-nowhere collapse that totally surprised the entire market!

The "TED Spread" is the difference between LIBOR and U.S. Government debt, and many used it in 2008 to track the financial crisis in real time (here's Krugman with "My Friend TED" from the time). Pushing LIBOR down makes the TED Spread look better. This looking healthier than it should meant that there was less pressure by regulators and legislators to find ways to allow these firms to fail, and that the most obvious way of dealing with the crisis was with a mass bailout. If you really want to deal with the crisis, you should affect either end of it that the price is reflecting, by either making the banks healthier or making sure we can deal with the failure.

The possibility that the regulators were in on it further clarifies the "protect the health of the largest banks at all costs" approach, one that squeezes every last bit of blood out of our turnip housing market and creates mass unemployment through a balance-sheet recession. And even if they weren't, that means that future measures to adeqately monitor the health of the banks through disclosures and market information might also be manipulated without (or even with) serious jail time or penalties.

This, by Smith, is wrong: "To my knowledge no one takes out an adjustable rate mortgage saying, 'what I really want is for my mortgage rate to reflect the level of panic in the global financial system should there by a once in 75 year crisis.' No, what everyone thinks is that they are getting the rate set by Federal Reserve and the Bank of England."

No, if that was the case there would be no use for LIBOR, and people would just use those rates. As Nemo summarizes in a great post on LIBOR from his bond series from years ago, the people pricing any loans at LIBOR want the pricing of a systemic credit crisis in their model. As Nemo says, "It is impossible to overstate how fundamental LIBOR is to the bond market." These prices are supposed to mean something, and the ability to add that information is a crucial reason it has shown up in so many pricing models. It would be a better world if those numbers weren't being manipulated to the advantage of inside traders.

Mike Konczal is a Fellow at the Roosevelt Institute.

  

In the most recent installment of “Fireside Chats,” the Roosevelt Institute’s Bloggingheads series, Fellow Mike Konczal talks with MSNBC host Chris Hayes, discussing the distortion of meritocracy and the problems of self-perpetuating elitism. As Konczal explains, the culture of “anxiety about the person who’s one step up from you” creates an environment where everyone knows everyone else is cheating, but "the rewards are so high, and conversely, the penalty for being left behind... [is] so severe, then even the most unethical things become a no brainer that you’re just compelled to take part of.”

“There’s the depth of failure but also the breadth of failure,” Konczal says. In a myriad of areas, from Washington and Wall Street to the test prep industry and steroids in baseball, the system we have now is a “meritocratic competitive arms race.” This has lead to extraordinary corruption and crisis in every sphere of American life, and with it a collapse of trust in our institutions that are increasingly run by distant elites. 

To add insult to injury, this elitism is self-perpetuating. Any organization, even if it begins as completely egalitarian and democratic, will have to utilize the mechanisms of meritocracy to determine some sort of leadership. However, Hayes explains that those who end up with this power will “inevitably use that disproportionate power to subvert whatever mechanisms of accountability, turnover, mobility,” that were initially in place. Konczal laments that things have gotten so bad that failures such as WorldCom and Enron “just feel like historical footnotes now compared to Lehman Brothers." He concludes that “People need to understand that the game is rigged.”

Watch the full video below:

The Senate may have brought JP Morgan CEO Jamie Dimon in for a hearing on the firm's $2 billion loss last week, but there was very little sizzle in his grilling. Instead of the kowtowing that took place, Roosevelt Institute Senior Fellow Rob Johnson told the Real News Network what questions he would have asked had he been in the room:

Question number one: "Why, when he claims what he’s doing is hedging other risk, he actually lost money on the hedge?" And as a follow up, to bring home the larger point: "Isn’t the Volcker rule, which separates all of this proprietary trading from other activities that society guarantees... absolutely necessary?" As Rob explains, this loss may not have been a significant portion of the bank's overall portfolio, but who's to say that the next loss isn't worse, or that a bank loses all of its capital the way Lehman did?

Question number two: "What was productive for society in the credit allocation process in that particular action?... Why does any of this activity have anything to do with making the economy function better, restoring the value or the stability in the housing market, or any of those types of real functions of financial mediation?" It can be easy to lose site of this point in all the talk of "job creators" and "doing God's work," but finance does exist for a purpose, in theory. So beyond maximizing stockholder's stock, what purpose was there for the rest of us?

And one final question: "I would be tempted to ask him why he spent so much money pulling together the entire lobbying force that used to work for Freddie Mac and Fannie Mae," Rob says. Such actions don't belie an interest in transparency, but quite the opposite: an effort to "thwart the public interest" and bury the important truths behind the bank's actions. So what are they hiding over there? If it's up to the Senate, we may never find out.