The Spider Network

by David Enrich

  Part II

  Ascendance

  Chapter 9

  What’s a Cabal?

  John Ewan was not happy. The past eight months had been stressful for the man in charge of Libor at the British Bankers’ Association. Starting the prior fall, he had been on the receiving end of a growing chorus of complaints about the benchmark. Phone calls and e-mails were pouring in from bankers who said the rate was divorced from reality. As the financial crisis intensified, banks’ borrowing costs were soaring. Yet Libor wasn’t moving. To make matters worse, the Bank of England was sniffing around about the rate’s accuracy. At a November 2007 meeting at the central bank’s headquarters, regulators and bank executives grumbled about Libor being too low. Ewan reassured participants that the BBA had rigorous quality control measures to prevent any problems.

  The reality was different. Ewan knew troubling things were afoot. Banks, terrified about the escalating financial crisis, were hardly lending to each other anymore. Giving money to another bank, even a relatively safe one, seemed to be a reckless act of doubling down on a highly distressed industry. The safer bet was just stashing money in accounts maintained at any number of central banks. That made the Libor estimates little more than guesswork. How could banks figure out how much it cost them to borrow from other banks if such borrowing wasn’t taking place? Plus, banks had a powerful incentive to err on the side of understating their borrowing costs. If it seemed like it wasn’t expensive for them to borrow, it might look to the outside world that they were more stable than a bank that faced higher borrowing costs, which would represent a bright red flag for jittery investors.

  One day, Ewan received a phone call from an acquaintance at Gulf International Bank. The Bahrain-based bank, which had a small London outpost, wasn’t on a Libor-setting panel. But the Gulf official had received a phone call from a bank that was on a panel, expressing interest in borrowing money from Gulf at a specific interest rate. Later that day, that same bank submitted Libor data that was a tenth of a percentage point—ten basis points—lower than what they’d been willing to pay Gulf to borrow. In other words, the bank had been citing a specific rate and hours later appeared to be understating its borrowing costs by a substantial margin. Something smelled fishy, the Gulf executive complained to Ewan. Before he could divulge the name of the offending bank, Ewan asked him not to. He didn’t want to know—such knowledge might force him to act on the allegations.

  Ewan had a new boss, named Angela Knight. Trained as a chemist, decades earlier she had run a small company before being elected to Parliament representing the Conservative Party in the mid-1980s. After losing a reelection bid, she decided to put her political connections to work, running a trade association for stockbrokers for the next decade. In April 2007, Knight joined the BBA as its CEO. She was a tough boss and prone to explosions. Ewan wasn’t interested in provoking her—and he knew that pushing her into a confrontation with the BBA’s members was a surefire way to cause ignition. Instead, Ewan decided to write a letter to the Libor banks, urging them to behave. At the very least, he needed to create a paper trail—“if only to be able to defend myself that I’m taking action if I’m stood up by the FSA or by a journalist or something,” he told an acquaintance.

  “I do not want the fixings to lose credibility in the market,” he pleaded to the FXMMC panel that was supposed to be overseeing Libor. He didn’t have any specific request other than for the bankers to think about the situation. Then he apologized for eating up their precious time.

  The responses trickled in, with some bankers explicitly stating that rivals were routinely lying about their borrowing costs. More evidence arrived the following spring. A BBA employee got an unsolicited e-mail from Deborah Wallis, who worked in the London office of a midsize German bank, Landesbank Berlin. It was clear to her that many banks’ Libor submissions were simply bogus. This was bad news for a bank like hers, because the wild, unpredictable swings in Libor made it much harder for Landesbank Berlin to make money by lending money to individuals and small businesses, its bread-and-butter business. Wallis had come to believe that the phenomenon was more serious than banks simply understating their borrowing costs for fear of appearing financially weak. “The problem is that they have a conflict of interest,” Wallis wrote. Many banks had big portfolios of derivatives whose values rose and fell with Libor, and she suspected that banks were basing their Libor submissions at least in part on those positions. “It is of course difficult for me to prove this but surely I’m not the only one to raise this question?”

  * * *

  Scott Peng dreamed of becoming an astronaut. He loved the idea of floating weightless above the earth, conducting trailblazing experiments that only a few dozen other humans had ever had the chance to perform. Born in Taiwan, Peng and his family moved to Swaziland when he was a young boy so that his father, a scientist, could teach advanced agricultural techniques to the southern African country’s subsistence farmers. After a few years, the family relocated another world away, to College Station, Texas, where the elder Peng took up teaching and research at Texas A&M University. By then, Scott’s genius-level brains were on full display. He graduated from high school at the age of fifteen and from Texas A&M, with a degree in nuclear engineering, three years later. The eighteen-year-old then headed to the Massachusetts Institute of Technology to get a Ph.D. in plasma physics. That’s when he met Franklin Chang Díaz, a former astronaut who had helped build the International Space Station and then became a part-time researcher at MIT. Chang Díaz dazzled his mentees, commuting up to Boston on a trainer jet—a modified version of an F-5 fighter—supplied by NASA. He and Peng worked together on research, jointly financed by NASA and the U.S. Air Force, into the next generation of rocket propulsion systems, which would rely on cutting-edge fusion technology. The former astronaut coached his protégé on what he would need to do to follow in his footsteps.

  Then Chang Díaz learned something devastating about Peng: He was nearsighted. Chang Díaz hadn’t realized it earlier because Peng wore contact lenses. The brilliant Peng somehow had neglected to look up the credentials of successful astronauts. Among them: twenty-twenty vision. Peng was crushed. Just like that, his dreams were shattered.

  Once he got over the shock, Peng had to figure out, quickly, what he wanted to do with his life. It was 1991, he was about to graduate from MIT, and a recession meant that jobs were scarce in the scientific field in which he had figured he would spend his professional life. While in graduate school, he had taken a few finance classes at MIT’s business school, so he put out some feelers to banks. Before he knew it, he had landed a job in New York creating exotic financial instruments at Lehman Brothers, at the time one of the world’s most aggressive investment banks. Peng joined the swelling army of engineers, mathematicians, and scientists heading to work on Wall Street.

  Notwithstanding the accidental nature of his career, Peng came to love working in banking. The challenges presented by designing and understanding complex financial vehicles like derivatives shared some traits with the challenges of creating newfangled rocket engines. One similarity was that not many people, aside from Peng, really grasped how either type of device worked, certainly not well enough that they could actually take them apart and then put them back together again.

  Peng was stimulated, but he didn’t like everything he saw among his Lehman colleagues. He was sitting with a group of four other traders who peddled something called structured notes to clients. At the time, in the mid-1990s, structured notes were among Wall Street’s hottest fads. A type of bond whose value was partly linked to derivatives, the notes were custom-made by investment banks on behalf of companies that were looking for new ways to entice investors to lend them money. Peng soon realized that most of those investors didn’t understand what they were buying or what the products were actually worth. The investment banks were taking advantage of that ignorance, which was a big part of the reason the market was booming.

  The practice
offended Peng. He’d been taught that properly functioning markets relied on all parties possessing similar levels of information—that was essential if market forces were going to achieve two of their signature goals: coming up with accurate prices and efficiently allocating capital. So in 1995 Peng set out to narrow the information asymmetry between banks and their clients: He wrote a book, The Structured Note Market: The Definitive Guide for Investors, Traders & Issuers, a four-hundred-page, decidedly nerdy volume.

  A decade later, Peng was still working on Wall Street, but no longer as a trader. He was now a researcher at Citigroup, writing detailed analytical pieces explaining the intricacies of the financial markets to the bank’s clients. The job was slower paced than being a trader, and Peng savored the opportunity to dig into and then illuminate the financial system’s musty corners. He wasn’t afraid of ruffling feathers by exploring topics that put the banking industry in an awkward spotlight. The tendency didn’t always endear him to his coworkers, as he learned after writing a piece that warned—presciently, it would turn out—of the perils lurking in a hot segment of the bond markets known as asset-backed commercial paper.

  In spring 2008, Peng’s latest research interest was Libor, a benchmark that was close to his heart because of its importance in the structured notes market. (Libor helped determine the values of many structured notes.) For the past several months, Peng had been picking up unsettling chatter about problems with the interest-rate benchmark. The financial crisis was intensifying, banks were paying more to borrow money, and yet Libor wasn’t budging. That didn’t make any sense—those borrowing costs were what the benchmark was supposed to be measuring. At that point, the market gossip was nothing more than hearsay. Then, in March, Bear Stearns collapsed. Central banks in several countries launched aggressive plans to try to stabilize the teetering financial system. One weapon in the Federal Reserve’s arsenal was doling out billions of dollars in loans to cash-strapped banks. The banks had to bid for the loans, and the prices they paid were made public. Here, Peng realized, was an easy way to measure banks’ approximate funding costs. He compared the data about the prices of the Fed loans with where the banks were reporting Libor. Sure enough, the figures diverged. The banks were paying high interest rates to borrow from the Fed, but Libor remained suspiciously flat—in other words, banks appeared to be understating their actual borrowing costs. Libor was artificially low.

  Peng typed up a quick five-page report, titled “Is Libor Broken?” To jazz it up, he stuck a modified Hamlet quote—“Something is rotten in the state of [Libor]”—at the top. Peng figured his report was going to cause a stir. After all, its clear implication was that banks were fudging their Libor data—an incendiary accusation, given Libor’s central place in the financial system. So he summoned his boss, an executive named Michael Schumacher, into a small meeting room. It was important to get his buy-in to ensure there wouldn’t be any blowback to Peng.

  “I wrote something, and I think it might be a little controversial,” Peng said. Then he handed Schumacher the draft.

  Schumacher scanned the report and then paused for a moment. “Go for it,” he said. The report was sent out to Citigroup’s clients, as well as a handful of reporters, on April 10, 2008.

  For a few days, nobody seemed to notice.

  * * *

  Fleet Street in London used to be swarming with journalists. Starting in the 1700s, more than a dozen newspapers set up shop along the narrow, winding road, vying for proximity to a huge audience of readers as well as the printing presses clustered in the area. Fleet Street soon became the media capital of the English-speaking world. That dominance lasted for a couple of centuries. By 2008, the name “Fleet Street” remained shorthand for the British media establishment. But the actual street bore few traces of its storied past—just a handful of ghostlike signs marking the places where long-dead newspapers like the People’s Journal once resided. The magnificent art deco headquarters of the Express now served as Goldman Sachs’s European headquarters, its gilded lobby off-limits to all but a few of the investment bank’s lucky visitors.

  A stone’s throw away from Fleet Street, across a busy intersection and up a steep flight of stairs, was a ten-story building covered in an exoskeleton of black marble and steel. The building’s unusual design garnered it architectural awards after it opened in 1993. Fifteen years later, the building was showing signs of its age. Carpets were stained and worn. Toilets regularly flooded. Overworked elevators—“lifts,” in the local parlance—often broke down. Nestled in a corner of the fifth floor was the London bureau of the Wall Street Journal. The group consisted of about a dozen reporters and editors, who occupied small cubicles divided by flimsy, chest-high dividers. One of the reporters was Carrick Mollenkamp, a lanky, well-dressed, hot-tempered, eccentric southerner. His cubicle and the surrounding floor were blanketed in papers, books, and back issues of Gray’s Sporting Journal, a hunting and fishing magazine. A textbook workaholic, he often didn’t leave the office until the wee hours of the morning, only to return a few hours later. He had a tendency of phoning sources or editors in the middle of the night, demanding that they answer his questions or tweak a headline. He didn’t believe in the concept of weekends. He consumed pots of coffee and packs of cigarettes every day. Some of his colleagues were terrified of his tendency to swing abruptly from chivalrous mentor to fiery screamer. A reporter in the London bureau jokingly described Mollenkamp as having “a face like a bulldog chewing a wasp.” On more than one occasion, he and other reporters had to be physically separated during newsroom altercations.

  Notwithstanding his tantrums, nobody questioned Mollenkamp’s talent; he churned out scoop after scoop, front-pager after front-pager. He was renowned for being one of the Journal’s best-sourced financial reporters. He had moles inside most of the big investment banks, everyone from rank-and-file traders and salesmen to C-suite executives. By the time Peng’s report on Libor landed in his inbox on April 10, Mollenkamp was already hard at work on a story examining problems with the benchmark.

  Months earlier, Mollenkamp had written a couple stories that mentioned Libor. He realized that he didn’t actually understand how Libor worked and, naturally curious, set out to learn all he could about it. One Saturday in March, alone in the Journal’s offices, he came across an obscure central bank research report that described Libor’s erratic behavior. Mollenkamp was intrigued. For the next couple weeks, he schlepped around London with a highlighted and underlined copy of the report folded in his pocket, showing the dog-eared document to his sources and soliciting their opinions. By then, Libor’s problems had become the subject of whispered conversations among banking officials and even regulators. (In early April, for example, a Barclays trader had phoned Fabiola Ravazzolo, an analyst at the New York branch of the Federal Reserve, which was responsible for monitoring big Wall Street banks. “We know that we’re not posting an honest Libor,” the trader said. Ravazzolo got off the phone and alerted her bosses.) Now such murmurings made their way to Mollenkamp.

  Mollenkamp’s editor was a longtime economics reporter named Mark Whitehouse. The rare journalist with an Ivy League business degree, Whitehouse had become the deputy London bureau chief in August 2007, after spending time in New York investigating subprime mortgages before it was cool to investigate subprime mortgages. In addition to being Mollenkamp’s boss, he was in many ways his polar opposite. Slightly built with floppy red hair, Whitehouse was so mild-mannered that he was sometimes mistaken as meek. As an editor, he was patient, deliberate, and slow. When Mollenkamp occasionally started kicking Whitehouse’s metal filing cabinets in frustration, the editor stared at him, refusing to react. Whitehouse didn’t even drink coffee. He sometimes showed up to the office wearing sandals with socks.

  A few days before Peng’s report was published, Mollenkamp had briefed Whitehouse on the planned story. The editor immediately grasped the potential magnitude. But Mollenkamp hadn’t found anyone willing to speak on the record about the
problems with Libor. Even though the concerns were widely held, Libor was so ubiquitous, such an ingrained part of the financial system, that publicly raising questions about its integrity seemed to border on blasphemy. Peng’s report therefore represented a breakthrough. Finally, someone—and someone affiliated with a major financial institution, no less—had dared to stake his credibility on the widely held critique. But Peng’s report also represented a threat to Mollenkamp: It was possible that some other reporter would read it and recognize the significance. Mollenkamp and Whitehouse accelerated their plans. Whitehouse patiently explained, over and over, to New York editors why Libor was so important and, therefore, why the story deserved prominent placement. At the last moment, the Journal’s page-one editors decided that they would take it. The story ran April 16, 2008. The above-the-fold headline was a play on London’s misty weather: “Libor Fog: Bankers Cast Doubt on Key Rate Amid Crisis.” The story opened: “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, bankers and traders are expressing concerns that the London interbank offered rate, known as Libor, is becoming unreliable.”

  * * *

  Before Peng even had a chance to sit down at his desk that morning, he was pulled into an urgent meeting. A handful of people were clustered in a conference room, with others piped in over an open phone line. Since publishing his Libor report, Peng hadn’t heard a peep from anyone, aside from a phone call with Mollenkamp. Now all hell seemed to be breaking loose. “Your piece has caused a lot of issues,” someone barked over the phone. Unbeknownst to Peng, Citigroup’s traders previously had amassed positions that stood to profit if Libor fell. Now, with the spotlight suddenly shining on the apparent tendency of banks to understate their borrowing costs, Libor had shot higher. The three-month iteration had leapt by 0.17 percentage points (or 17 basis points), the biggest jump in eight months.