The Spider Network

by David Enrich

  In 2008, Gensler took advantage of the connections he’d forged at Goldman and in Washington and acted as the Obama campaign’s unofficial liaison to Wall Street. It wasn’t exactly an awe-inspiring position. Once, he gathered the CEOs of several big banks in a private room at the Willard hotel, across the street from the Treasury Department and a stone’s throw from the White House, to explain to them why supporting Obama was in their best interests. Lloyd Blankfein, who as Goldman’s CEO was the unofficial King of Wall Street, showed up a little early. As soon as Gensler arrived, Blankfein walked up to say hello—and goodbye. “I don’t think I will be able to stick around,” he said. Gensler, sensitive to his standing with powerful people, took it as a slight.

  Obama soon rewarded Gensler for his support, nominating him to become the chairman of the CFTC—the same role that Born had stepped down from a decade earlier after pressure from Treasury officials including Gensler. By now Rubin’s breed of Wall Street–loving Democrats had fallen out of favor amid a financial crisis. Gensler’s nomination encountered stiff resistance from liberal senators. “At this moment in our history, we need an independent leader who will help create a new culture in the financial marketplace and move us away from the greed, recklessness, and illegal behavior which has caused so much harm to our economy,” Senator Bernie Sanders said as he announced his intention to block Gensler’s appointment.

  Gensler, fifty-one at the time, knew what he had to do: Cleanse himself of his now-toxic centrist credentials. He launched an offensive to convince his doubters that, if confirmed, he would embrace a tough-on-Wall-Street approach, transforming the sleepy CFTC into a force to be reckoned with. He wowed one critic at a big public-interest group by conceding that he had erred in the past with his laissez-faire views—a rare acknowledgment of screwing up from a public official. The about-face worked. The Senate voted to confirm Gensler as CFTC chairman, and he started the job on May 26, 2009.

  * * *

  Thomas Youle and his fellow graduate student Illenin Kondo had spent the day and now much of the night in a cramped office they shared at the University of Minnesota, where they were both pursuing doctorates in industrial organization, a branch of economics. All day they had been sifting through financial data in between bantering about economics and current events. Now the two night owls walked home to the house they shared in Dinkytown, across the Mississippi River from the economics department. Youle loved walking over the 10th Avenue Bridge, inspired by the wide river and the wider sky. In the winter, when the temperature sometimes dipped to minus 40 degrees, Youle would still trudge across, sometimes moving backward to shield his thin, boyish face from the bitter wind. On this May night, the dark brown river was barely visible, though Youle could hear it churning below.

  Like Gensler a Maryland native and math whiz, Youle had always wanted to be a professor. But now that he was on that career path, he was struggling mightily to choose a topic for his doctoral thesis, a subject to which he would devote the next couple of years—if not more—of his life researching. His initial idea had been to look at competition in the Texas electricity markets. His thesis adviser, an economist named Patrick Bajari, told him that sounded dull. How about pursuing something related to banking? The industry was in the throes of a nasty crisis—surely there were sexy topics to explore. So Youle, not knowing where to begin, embarked on a needle-in-a-haystack search for a topic. Every federally regulated bank periodically has to fill out something known as a “call report,” jammed with heaps of granular data about all aspects of its balance sheet. The call reports were publicly available, but finding anything in them was next to impossible for a layperson. Youle found a way to download, in bulk, every big bank’s data. He spent the next several months aimlessly wandering through the numbers. When he occasionally encountered something that sounded interesting, he bounced it off another grad student, Connan Snider, a couple of years ahead of him. Snider wasn’t shy about telling Youle that his ideas were lame, which they generally were. Youle did, however, unearth some interesting nuggets. For example, he learned that some of the biggest American banks, such as Citigroup and J.P. Morgan Chase, were stuffed with trillions and trillions of dollars of derivatives linked to interest rates, particularly Libor. Youle socked that knowledge away and kept hunting.

  As Youle and Kondo walked across the bridge, their conversation turned to Libor. The apparent problems with the rate—the fact that banks seemed to be deliberately understating their borrowing costs—had been in the news, and one of Bajari’s colleagues had pursued preliminary research into the area. Suddenly, in Youle’s mind, something clicked. It was so simple: Libor was set by banks that—he knew from the call reports—were sitting on mountains of derivatives that hinged on Libor. Was it possible that what everyone had assumed was the reason for the skewing—banks’ efforts to trick the public into thinking their funding costs were lower, and the institutions were healthier, than they really were—was only part of the story?

  The next day, Youle told Snider about his eureka moment. Could this work as a thesis topic? For once, Snider smiled. “Now that is a good idea!” he exclaimed. The two started brainstorming about statistical methods he could use to prove that banks were messing with Libor to benefit their portfolios of interest-rate derivatives. The more they talked, the more excited they became. Snider offered to work with Youle on the project; Youle said yes. Then they explained their idea to Bajari. He, too, was pumped. It meshed nicely with his area of expertise: ways to prove whether firms were operating collusively.

  Now the question became how to go about proving their hypothesis. Snider and Youle spent an afternoon toying around with a primitive game-theory model. Then they looked at alternative data sources on banks’ borrowing costs to gauge Libor’s accuracy—similar to the methodology that Mollenkamp and Whitehouse had used in their Journal piece a year earlier. Over the following weeks, they dug through research about how different prices for medical care altered consumers’ behavior, creating a phenomenon known as bunching in which people clustered around certain price points. Drawing on that research, they devised several categories for Libor submissions: highest, lowest, and a few middle tiers. Youle spent some time working in the offices of the Federal Reserve Bank of Minneapolis, which was equipped with a nearly magical tool: a Bloomberg computer terminal crammed with just about every bit of financial data imaginable. After he downloaded a couple of years’ worth of Libor submissions for dozens of banks, across a half-dozen currencies and many different time periods, Youle and Snider laboriously entered the data into a spreadsheet and then divided the submissions into the high, low, and middle categories. If nothing weird was going on, they figured, the submissions should have been evenly spread, more or less, across all the categories.

  But when they plotted the data on a chart, the submissions appeared clustered around the fringes of the highest and lowest categories. Because of the way Libor was calculated—with the highest and lowest submissions thrown out, and the rest averaged—banks that wanted to move the rate would have had to aim for the highest or lowest possible levels without being knocked out of the average. When the two students looked at the chart, the bunching phenomenon jumped out at them.

  This, they realized, wasn’t the behavior of banks trying to mask their rising borrowing costs by submitting artificially low Libor data. It was the behavior of banks trying to push the benchmark in very specific directions.

  “Holy shit, this is great!” Bajari blurted when Youle and Snider briefed him. He instructed them to write a paper that could be published quickly—hardly the norm in an academic field where peer-reviewed articles can languish for years. “People are going to steal this idea,” he warned. His students thought Bajari seemed to be thinking more like a scoop-hungry journalist than a perfectionist academic.

  About six months later (quick in academia), after countless all-nighters and considerable hounding from the impatient Bajari, Youle and Snider completed a draft of their article. It ran thirty pa
ges, including several pages of charts attached at the end, and was titled: “Does the Libor reflect banks’ borrowing costs?” They noted the consensus view—held by everyone from the Journal to the CFTC—that Libor manipulation appeared to be motivated by lowballing. Their research, they wrote, “points to a more fundamental source, namely that bank portfolio exposure to the Libor give them incentives to push the rate in a direction favorable to these positions.” The technical language masked the importance of what they had found.

  They submitted the paper to a bunch of academic journals. An editor at the Journal of Finance, the field’s foremost publication, was among those who shot it down. “This is ridiculous,” the editor huffed. “Even if it’s true, who would care?”

  Nobody would publish it.

  * * *

  Gensler hit the CFTC like a hurricane. He was brilliant, and he knew it, accustomed to always being the smartest guy in the room. And he was blunt, sometimes brutally so. He could be intimidating, partly because of his demeanor (anyone who interpreted his tendency to preside over meetings while slouched in a chair with his loafers off as a sign he was laid-back was in for an unpleasant surprise) and partly because of the sheer weight of financial expertise he was carrying around in his brain. “I don’t think you know what you’re doing” was a common Gensler refrain if he took issue with an employee’s work. His no-holds-barred approach might work on a Goldman Sachs trading floor, but it was jarring inside a staid government agency staffed by not-very-well-paid civil servants. He sowed discord with some of his fellow commissioners, threatening to plant negative stories about them in the media if they didn’t vote the way he wanted them to.

  Gensler also had a softer side. His wife, Francesca Danieli, an artist, had died of breast cancer in 2006 at age fifty-two, and the widower was deeply devoted to his three daughters. He maintained his home in Baltimore and commuted to Washington every day, taking the 7 a.m. train there and the 7 p.m. one home. If his youngest daughter needed help with her homework, Gensler would pack his briefcase and catch an earlier train home. After the girls went to bed, he would pick up where he’d left off at the office. Colleagues routinely fielded his phone calls after 11 p.m.

  Many employees gradually warmed to Gensler, even if they detested his pit-bull personality. Sure, he was tough, but his goal of trying to empower what had been a federal backwater was worthy. While many regulatory agencies had relied on narrow, conservative interpretations of their responsibilities in order to avoid wading into controversial territory, Gensler encouraged staff to search widely for new areas in which they could assert their authority. One day that spring, Stephen Obie briefed Gensler on the cases that the enforcement division was working on. Included in the rundown was the Libor investigation. Gensler liked what he heard.

  * * *

  In an office park adjacent to San Francisco International Airport, two attorneys, Joseph Cotchett and Nanci Nishimura, had been toiling on a lawsuit against some of the world’s biggest banks. Brash, cocky, and hard of hearing, with his thinning white hair combed straight back, Cotchett had been a Special Forces paratrooper after he graduated from college with an engineering degree in 1960. Then he became a lawyer—a flamboyant one. He dressed in gaudy suits. He once showed up in a London criminal court as a spectator and loudly critiqued the prosecutor’s tactics, earning a stern rebuke from the white-wigged judge. His drink of choice was red wine, with several ice cubes sloshing around in the glass. His decaying marriage had become fodder for Bay Area tabloids, which regaled readers with rumors about Cotchett’s alleged proclivity for parading around his house naked in the presence of his teenage daughters. (Cotchett denied those allegations.) But he was one of the country’s best-known trial lawyers, a heavyweight Democratic donor who had taken cases to the Supreme Court. Cotchett and Nishimura had spent years consumed with their case against banks. It claimed that U.S. towns and cities, including Los Angeles, had bought derivatives designed to protect them against big swings in interest rates but that banks had engaged in anticompetitive practices to steer municipalities to derivatives that—no surprise—benefited those banks (or their employees or friends). Cotchett was enraged by the manner in which the banks had exploited unsophisticated customers, but it also made his mouth water: His firm pocketed a boatload of fees when lawsuits like this won in court or, as more often happened, yielded giant settlements with deep-pocketed defendants eager to avoid the time-consuming and potentially embarrassing discovery process.

  In scouring clients’ derivatives contracts as part of that lawsuit, Nishimura had repeatedly encountered Libor (it was embedded in many of the derivatives). Now, in spring 2009, she started seeing Libor pop up in occasional stories in the financial media. The government was clearly sniffing around, and Nishimura had a pleasing thought: If Libor was manipulated, up or down, it almost certainly had an impact on her municipal clients. Some of them had derivatives that were supposed to pay out if Libor moved higher; others had the opposite positions. Either way, this looked like easy money. “This could be a huge case,” she told Cotchett, who didn’t disagree. Nishimura started canvassing clients to see if they’d be interested in exploring a class-action lawsuit against the banks for manipulating Libor. It wasn’t a hard sell. The deepening recession had caused tax revenues to dry up all over the country, and cities and public entities, like the University of California system, were eager to find ways to refill their coffers. Going after the banks seemed more than fair, considering the disproportionate role they’d played in capsizing the American economy.

  The city of Houston, already a plaintiff in the derivatives case, was one of the first to sign up to join a Libor suit; its mayor issued a press release declaring that it wasn’t a question of whether the city was owed money by the banks for stiffing them on Libor, but how much the city was due. Louisiana’s attorney general invited Nishimura to make a presentation to state officials. She flew to New Orleans, where a lawyer picked her up at the airport and drove her the seventy miles to Baton Rouge. As they passed beat-up pickup trucks with gun racks and Confederate flag bumper stickers, the petite, well-dressed Asian-American woman felt out of place. But by the time Nishimura’s escort led her into Louisiana’s thirty-four-story art deco capitol building, she had managed to calm her nerves. She addressed a roomful of angry, and surprisingly smart, finance officials from around the state. They told her that many struggling parishes had purchased derivatives that, for one reason or another, weren’t delivering the anticipated financial rewards. Few of the officials had read the contracts’ details. Most didn’t know what Libor was. A few assumed it was an official interest rate set by a British government agency. None of them had heard of the BBA.

  * * *

  Once a year, many of the world’s leading financial regulators gathered at a sprawling estate in the English countryside. About two hours by car outside London, Wiston House was built in the late sixteenth century on a property that spanned six thousand acres of rolling hills and farmland. The majestic stone mansion was straight out of Downton Abbey. Wiston House now served as an elaborate conference center, and a British government agency charged with organizing meetings to enhance global unity was one of the main outfits that used the space. Among its events was the annual regulatory shindig.

  Gretchen Lowe was unhappy when she arrived. Back in Washington, her bosses, McGonagle and Obie, had been growing antsy. The Libor investigation appeared dormant. Part of the problem was the vague, open-ended questions the CFTC had sent out to banks and the BBA. Plus, the initial round of queries was voluntary—was it really a surprise that few banks had bothered to respond? But an equally severe problem was that the FSA seemed to be taking its sweet time forwarding the Americans’ requests for information to London-headquartered institutions. That was playing right into the hands of the industry, which was hoping the CFTC would find something better to do with its time. The FSA’s apathetic attitude seemed to border on passive-aggressive.

  At Wiston House, Lowe bumped into F
SA enforcement honcho Margaret Cole. Lowe pulled her aside and, doing her best to remain diplomatic, explained that the CFTC was treating the case as one of its highest priorities. She confided that the newly arrived Gensler was heaping pressure on his staff to find ways to overcome the agency’s weak reputation. Lowe told Cole that she hoped the FSA would take the inquiries seriously. At the end of the chat, Lowe was left wondering whether Cole cared.

  * * *

  Hayes, in addition to having neither tucked in his shirt nor shaved, was damp when he arrived at Citigroup’s London headquarters on a Thursday in October 2009. The driving rain had rendered umbrellas useless, and he was running late. That’s what a month of gardening leave will do to you, he had thought to himself when he realized that he had misremembered the start time of the day’s first meeting.

  Citigroup wasn’t his employer yet. He technically remained on UBS’s payroll, and he wasn’t supposed to be doing any work—certainly not interacting with his new company—until his compulsory three-month hiatus ran its course. The only reason he was even at Citigroup’s offices that morning was that he happened to be in London. Back in Tokyo, Hayes’s eyesight had been bothering him for a while. Now that he had a few months off, he checked himself into London’s Moorfields Eye Hospital for laser surgery. He also was starting to scout for houses that he and Tighe potentially could buy in his hometown of Winchester. When he’d mentioned to his soon-to-be Citigroup colleagues that he’d be in England, they suggested he stop by for a visit. So here, a bit soaked, he was.