The Spider Network

by David Enrich

  One of Peng’s colleagues angrily told him that he had just cost the bank $10 million. Plus, another official chimed in, the BBA was irate. Someone at the trade association had called that morning and was demanding that Citigroup retract Peng’s report. His colleagues were inclined to bow to the pressure rather than fight the powerful group. Peng replied that he would be happy to retract the report if anybody could identify inaccuracies in it. Nobody did, so the report stood. But that didn’t stop his colleagues from bad-mouthing him. “My personal view is that Scott Peng was rather distant to the whole process and would not really have known about the intricacies of Libor, not being an expert in the money markets,” Andrew Thursfield, Citigroup’s representative on the Libor oversight committee, would later declare.

  A few hours after Peng’s dressing-down, Angela Knight dashed off a letter to banks about Libor. She said the BBA planned to accelerate its annual process of reviewing the rate, and she invited any input about ways to improve its credibility. And she noted that recent, negative analyst research by banks like Citigroup was exacerbating the problem.

  Later that day, the BBA held a two-hour board meeting in its offices. One attendee was a longtime Deutsche Bank executive named Charles Aldington. A former trader, Aldington was now chairman of the German bank’s British operations. In the meeting, he alleged that many banks were not only downplaying their borrowing costs to avoid the harsh glare of publicity, but also were engaged in outright manipulation to enhance the value of their derivatives trades—just as Deborah Wallis had suspected. By now, Ewan had heard several warnings like this, but Aldington’s explicit tone surprised him. The next day, Ewan called Deutsche Bank’s David Nicholls to discuss Aldington’s remark. The fast-talking Canadian managed some of the bank’s highest-paid traders. Ewan asked him what Aldington had been referring to. Nicholls hurled the ugliest insult he could think of: Aldington wasn’t even really a trader, at least not in any recent decade. “If you’re going to be a top trader, you’re not going to be making those comments. No bank could manipulate Libor.”

  “A cabal of them could,” Ewan tentatively suggested.

  “What’s a cabal?”

  “A group together could.”

  “That’s an interesting conspiracy theory.”

  “I’m playing devil’s advocate,” Ewan clarified.

  “Banks do not collude to try to set a Libor rating,” Nicholls lectured. He added that he was “very confident” that the media and analysts like Peng simply didn’t understand how Libor worked. Then he whipped through a detailed dissertation about derivatives and their relationship to Libor. Ewan was lost. “I must admit, I wouldn’t want to try to effectively reconstruct that argument,” he sheepishly admitted to Nicholls.

  Nicholls wasn’t done. “I think I’m just hearing a lot of hysteria,” he said. “The talk that some institutions are manipulating Libor . . . is so far from factual.”

  The BBA embarked on a weeks-long campaign to convince everyone—investors, regulators, the media, the public—that all was well with Libor. Ewan took the lead, producing a flurry of research reports insisting that even in the worst case, Libor only needed very minor adjustments. He also tried to convince the press to stop writing about Libor, meeting with Mollenkamp and his competitors at the Financial Times to assure them that there was nothing worth looking into. Ewan struck Mollenkamp as a lightweight. The entire BBA, for that matter, seemed out of its depth with Libor. At times, the frustration boiled over. Screaming matches erupted between the hapless Ewan and Mollenkamp, who perceived the BBA as trying to hide the increasingly obvious problems with its flagship product.

  For her part, Knight wrote a typo-strewn e-mail to bank CEOs asking them to “secure specific posative comments” from research analysts and to make sure we “have them on side . . . We need to reinforce Libor.” The efforts were not entirely successful. A Barclays researcher named Tim Bond, apparently not having received the marching orders, went on TV and said what he claimed everyone by now knew: Libor had become “a little bit divorced from reality.” Bond added that the prior September, Barclays had gotten sick of submitting bogus data and decided “to quote the right rates.” The implication was that most of Barclays’s competitors were not doing the same. Knight couldn’t believe one of her member banks was throwing fuel on the fire. She lodged a complaint with a senior Barclays executive, Gary Hoffman. “In effect,” she e-mailed him, “we are in a position whereby some less than helpful actions by some banks and less than helpful comments in a febrile atmosphere has created a serious problem out of a market issue.”

  “Sorry about that,” Hoffman apologized. “Even if what he is saying is true (which it is), I’m not sure what the benefit is to Barclays or the industry.”

  On April 25, Knight met with senior British bankers and officials from the Bank of England at the central bank’s headquarters. She told them she was in the midst of a “charm offensive” in London and New York to convince journalists, hedge funds, and others that Libor wasn’t irreparably broken. Then she dropped a bombshell: Maybe, she said, a trade group like the BBA shouldn’t be responsible for such an important financial benchmark? Perhaps regulators or central bankers should be involved in administering or at least overseeing it. She was greeted with blank stares. Nobody wanted to be responsible for this mess.

  * * *

  The first weekend in May, the world’s most powerful central bankers gathered in Basel, Switzerland, for a regular meeting at the Bank for International Settlements, a sort of central bank for the world’s central banks. On Sunday evening, an elite handful peeled off for what one journalist dubbed “the most exclusive regular dinner party on the planet.” The gathering was known as the “Informal Dinner for Governors of the Economic Consultative Committee.” It took place on the eighteenth floor of the BIS’s cylindrical tower, which like the United Nations technically sat on international soil. From the United States, Federal Reserve governor Ben Bernanke and Tim Geithner, at the time the head of the New York Fed, were there, as were the governors of the central banks of Japan, Germany, France, Italy, Canada, and Switzerland. Also in attendance was Mervyn King, the owlish, tradition-bound governor of the Bank of England. At the dinner, Geithner grabbed King for a brief chat to discuss Libor.

  Geithner’s research staff in New York, including Ravazzolo, had been digging into the benchmark. They were especially fascinated by the sharp move in Libor following the Journal’s April 16 story. They euphemistically referred to the spike as a “repricing event.”

  Geithner told King he had some thoughts on how to improve Libor. King said he would welcome the suggestions and asked the American to write him at a later date to explain his thoughts. The conversation didn’t last long. King and Geithner were always in high demand, and King wasn’t a big fan of impromptu conversations, especially about sensitive topics.

  * * *

  On May 19, the FXMMC gathered for what was probably its most important meeting ever. Representatives of seven banks attended, as did Ewan and three BBA colleagues. Ewan kicked things off: They needed to address the problems surrounding Libor. The room quickly got an earful from one banker, who said that the fundamental problem was the media and yearned for a return to the days when nobody was looking into the industry. Debate shifted to whether and how to change Libor. One problem was that any change could ripple throughout the financial system because so many financial contracts—everything from mortgages to derivatives—contained language linked to Libor. “We need to adopt a minimal approach,” another banker said. “Too big a change would cause an explosive reaction.” But the absence of change could be just as damaging, someone else warned. Everyone knew this meeting was taking place; if it ended without any action, what would people think? So, what to do about banks that submit bogus data? The consensus: not much. “Policing should be done by just picking up the phone . . . and have a conversation behind closed doors,” a banker said, winning nods of ascent from his colleagues.

  The m
eeting concluded with no progress.

  A few days later, the FSA met with the BBA. The regulators pointed out to Ewan and his colleagues that Libor’s “accuracy is poor.” But the agency wasn’t interested in getting involved. Despite the onset of the financial crisis, it was clinging to its light-touch strategy.

  * * *

  For their next project, Mollenkamp and Whitehouse set out to prove that Libor was broken. They decided to look at an instrument called credit default swaps. These were basically insurance contracts between a bank and another party that paid out if a company defaulted on its debts. Investors used the instruments to protect themselves when they were buying corporate bonds. This way, if the bonds defaulted, the swaps would make up for their losses. The swaps had another interesting feature, which is what appealed to the Journal reporters: Their prices fluctuated along with the perceived riskiness of the company whose bonds they insured, and as a result they were a decent proxy for companies’ borrowing costs. (As a company became riskier, buying insurance on its bonds became more expensive; similarly, lenders would demand that the company pay higher interest rates on any loans.) Whitehouse, the math whiz of the two, started building a massive Excel spreadsheet that compared banks’ CDS prices with their Libor data over a several-month period. The finished spreadsheet showed that many banks’ Libor submissions had little resemblance to their CDS prices and, therefore, their apparent funding costs.

  The story hit on May 29 with the headline “Study Casts Doubt on Key Rate.” Like the April 16 article, it ran on the paper’s front page. The story focused on especially suspicious data being submitted by Citigroup, UBS, and a few other banks. It quoted two statistics professors who validated the methodology and significance of the Journal’s analysis, as well as a man from Del Mar, California, whose monthly mortgage payments had leapt higher as a result of bizarre movements in Libor. Mollenkamp and Whitehouse further noted that some public-sector entities—hospitals, schools, and governments—that relied on instruments linked to Libor to protect against swings in interest rates were increasingly worried about the benchmark’s integrity.

  This time, the reaction was swift. The banking industry went into overdrive to destroy the story’s credibility. J.P. Morgan took the unusual step of publishing a piece of research specifically aimed at debunking an article, calling the Journal story “deeply flawed.” “Do I think that Libor is perfect? No,” wrote Felix Salmon, one of a number of well-known bloggers to blast the Journal’s piece. “In this world, no spread measure is going to be perfect, especially at tenors of longer than a couple weeks. But Libor is not nearly as flawed as the WSJ makes it out to be.”

  The public broadsides and lack of public affirmations discouraged Whitehouse. With an epic financial crisis brewing, he decided to move on to other topics. Mollenkamp, after six weeks of relentlessly churning out minor and major Libor stories, also soon shifted gears.

  Nevertheless, just about everyone with any business trading derivatives linked to Libor read the Journal stories. Goodman had forwarded the original April 16 article to Read, who’d been impressed—it was the clearest articulation he’d seen of what was going on with Libor—and passed the story on to Hayes. The trader took solace in the article’s focus on the U.S. dollar version of Libor, not the yen one in which he specialized. Besides, the article wasn’t focused on traders; it dwelled on banks understating their Libor submissions as a way to project images of financial strength. The next day, Hayes had texted Goodman his latest Libor-moving request.

  By the time of the second article, though, the Journal’s onslaught grated. “Just trading like a monkey,” Hayes told a colleague. “Bit worried about this bloody Libor story.” He speculated to a friend that perhaps ICAP, now pushing its own benchmark to rival Libor, was the source of the Journal stories.

  In London, RBS traders and ICAP brokers bantered about the article. “When they mean dodgy Libors, don’t they mean Tom Hayes?” Neil Danziger hollered over a squawk box.

  * * *

  Vincent McGonagle plopped down into his leather desk chair in a corner office at the Commodity Futures Trading Commission. Springtime was short in Washington. Not much time separated the chilly, wet winter from the stifling heat, humidity, and mosquitos of summer in the drained swamp that served as the nation’s capital. April 16 was one of those all-too-rare spring days, warm but not hot, a few clouds but no threat of rain. Along the Potomac River and the National Mall, delicate pink-and-white cherry blossoms flowered.

  The CFTC was in Washington’s downtown business district, a tidy grid of modern buildings occupied mostly by law firms and trade organizations whose businesses revolved around lobbying federal policy makers. McGonagle’s seventh-floor office, with plush blue carpeting and enough space for a sofa and coffee table, overlooked an adjoining building whose roof was jammed with satellite dishes. He was the second-highest official in the agency’s enforcement division, which was supposed to ensure that market practitioners adhered to the rules governing the sales and trading of everything from pork belly futures to interest-rate swaps.

  McGonagle, with bushy eyebrows and sandy blond hair, bore a slight resemblance to Robert Redford. Raised in a small Philadelphia suburb, after law school McGonagle had devoted his entire professional life to government service and had been at the CFTC since 1997. Inside the agency, he was known as a low-key and friendly fellow, a straight shooter, a bit cautious, not someone who would bend the rules or push the envelope. At industry conferences, as colleagues sipped complimentary drinks and mingled with finance executives, the socially awkward McGonagle tended to huddle in a corner talking to other CFTC officials. At times, his behavior led colleagues to wonder whether he had Asperger’s syndrome, a mild form of autism.

  The original mandate of the CFTC, founded in 1975, was to regulate the fast-growing universe of futures and other instruments being traded on exchanges like Chicago’s Merc. But the agency never managed to establish a reputation as important, partly due to the efforts of sharp-elbowed rival bodies like the Securities and Exchange Commission to eat away at its turf. When a soon-to-be member of the agency’s board was awaiting Senate confirmation, a former agency official gave him a warning: “You’re going to need a hobby.” The CFTC was so slow-moving, so dull that being one of its five commissioners wasn’t considered a full-time job. (One commissioner tended to work from his home in Arkansas, only occasionally showing up at the agency’s headquarters.) Staff cycled through the agency on their way to lucrative jobs representing companies that had business before the commission.

  The CFTC’s technology was embarrassingly antiquated—a problem that dogged plenty of federal agencies, but especially troubling for one charged with overseeing vast, complex financial markets. Up until around 2010, the CFTC still allowed institutions to submit their trading records by fax each evening; staffers then had to manually input the numbers into creaky spreadsheets. By the time the figures were processed, they were obsolete.

  The agency’s weak reputation was compounded by its seemingly obsessive focus on small-bore cases. McGonagle and a small cadre of other enforcement officials had been trying to overcome that image. Earlier in the decade, alerted by the collapse of Enron to a new class of frauds involving energy companies manipulating markets, the CFTC started homing in on bigger targets. The agency, partnering with the Justice Department, nailed several executives for trying to rig oil price benchmarks that were based on data submitted by energy trading companies. But the cases took forever to put together. McGonagle wanted to find some way to quickly establish the CFTC’s street cred.

  Each morning, McGonagle received an e-mail from an agency staffer that contained a list of the day’s news stories that affected the universe that the CFTC was supposed to be overseeing. On April 16, he scrolled through the clippings. The synopsis of the Journal’s story caught his eye. He clicked on the link and read the full piece. Then he read it again.

  * * *

  For the next couple of weeks, McGonagle d
id some preliminary research on Libor—what it was, how it worked, why it mattered. One day, he walked down the hall to the office of his deputy, Gretchen Lowe. The enforcement division was housed in a warren of narrow passageways lined with tall file cabinets. Little natural light filtered in. Lowe, tall, gangly, and bespectacled, had been at the CFTC even longer than McGonagle. She liked being an underdog, going toe-to-toe with banking lawyers who she knew were taking home in a month what Lowe and her ilk earned in a year.

  She and McGonagle discussed the Journal story and whether there was more to it. The only way to answer that was to launch an investigation, but that was easier said than done. The agency was constantly battling budget shortages (resources were so tight that employees had to bring their own coffee mugs to work), and investigations were expensive: Agents had to fly all over the world, lawyers had to be hired, depositions recorded. Before going any further, McGonagle and Lowe needed to alert their higher-ups.

  Their manager was Stephen Obie, who was running the CFTC’s enforcement arm. Raised in the Bronx, Obie was the son of a New York City bus driver. A decade earlier, he had been toiling as an associate at a major law firm, trying to figure out what he wanted to do with his life. A colleague gave him some advice: Lawyers were becoming like doctors—if they didn’t develop specialties, they became dispensable. The way to build a specialty, he was convinced, was to work for a government agency, so Obie applied for jobs at the CFTC and at the New York City Transit Authority, the same agency that had employed his father. Both made offers, and he opted for the CFTC gig, partly because of its convenient New York location in the North Tower of the World Trade Center. He joined in 1998 as a trial lawyer. The learning curve was steep, but the transition was made easier by the CFTC’s tradition of targeting small fries. For a while, Obie’s big get was busting a couple of California taxi drivers for fraud.