LIBOR Rigging
July 5th, 2012
LIBOR (the London inter-bank offered rate) scandal that involves Barclays, a 300-year-old British bank, is beginning to assume global significance. Over the past weeks damning evidence has emerged, in documents detailing a settlement between Barclays and regulators in America and Britain that employees at the bank and at several other unnamed banks tried to rig the number time and again over a period of at least five years. And worse is likely to emerge. Investigations by regulators in several countries, including Canada, America, Japan, the EU, Switzerland and Britain, are looking into allegations that LIBOR and similar rates were rigged by large numbers of banks.
The LIBOR that the traders were toying with determines the prices that people and corporations around the world pay for loans or receive for their savings. It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year. Yet it turns out to have been flawed.
On July 3rd, Barclays PLC Chief Executive Robert Diamond caved in to intense pressure to quit after the U.K. bank became embroiled in a bitter political row over its role in the Libor rate-rigging scandal. Robert Diamond resigned amid a deepening dispute about whether the Bank of England pushed the lender to submit artificially low Libor rates during the financial crisis.
As many as 20 big banks have been named in various investigations or lawsuits alleging that LIBOR was rigged. The scandal also corrodes further what little remains of public trust in banks and those who run them.
Like many of the City’s ways, LIBOR is something of an anachronism, a throwback to a time when many bankers within the Square Mile knew one another and when trust was more important than contract. For LIBOR, a borrowing rate is set daily by a panel of banks for ten currencies and for 15 maturities. The most important of these, three-month dollar LIBOR, is supposed to indicate what a bank would pay to borrow dollars for three months from other banks at 11am on the day it is set. The dollar rate is fixed each day by taking estimates from a panel, currently comprising 18 banks, of what they think they would have to pay to borrow if they needed money. The top four and bottom four estimates are then discarded, and LIBOR is the average of those left. The submissions of all the participants are published, along with each day’s LIBOR fix.
In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten.
First, it is based on banks’ estimates, rather than the actual prices at which banks have lent to or borrowed from one another.
A second problem is that those involved in setting the rates have often had every incentive to lie, since their banks stood to profit or lose money depending on the level at which LIBOR was set each day. Worse still, transparency in the mechanism of setting rates may well have exacerbated the tendency to lie, rather than suppressed it. Banks that were weak would not have wanted to signal that fact widely in markets by submitting honest estimates of the high price they would have to pay to borrow, if they could borrow at all.
In the case of Barclays, two very different sorts of rate fiddling have emerged. The first sort, and the one that has raised the most ire, involved groups of derivatives traders at Barclays and several other unnamed banks trying to influence the final LIBOR fixing to increase profits (or reduce losses) on their derivative exposures. The sums involved might have been huge. Barclays was a leading trader of these sorts of derivatives, and even relatively small moves in the final value of LIBOR could have resulted in daily profits or losses worth millions of dollars. In 2007, for instance, the loss (or gain) that Barclays stood to make from normal moves in interest rates over any given day was $40m at the time. In settlements with the Financial Services Authority (FSA) in Britain and America’s Department of Justice, Barclays accepted that its traders had manipulated rates on hundreds of occasions.
Barclays has tried its best to present these incidents as the actions of a few rogue traders. Yet the brazenness with which employees on various Barclays trading floors colluded, both with one another and with traders from other banks, suggests that this sort of behavior was, if not widespread, at least widely tolerated.
Yet a second sort of LIBOR-rigging has also emerged in the Barclays settlement. Barclays and, apparently, many other banks submitted dishonestly low estimates of bank borrowing costs over at least two years, including during the depths of the financial crisis. In terms of the scale of manipulation, this appears to have been far more egregious—at least in terms of the numbers. Almost all the banks in the LIBOR panels were submitting rates that may have been 30-40 basis points too low on average.
As the financial crisis began in the middle of 2007, credit markets for banks started to freeze up. Banks began to suffer losses on their holdings of toxic securities relating to American subprime mortgages. With unexploded bombs littering the banking system, banks were reluctant to lend to one another, leading to shortages of funding system-wide. This only intensified in late 2007 when Northern Rock, a British mortgage lender, experienced a bank run that started in the money markets. It soon had to be taken over by the state. In these febrile market conditions, with almost no interbank lending taking place, there were little real data to use as a basis when submitting LIBOR. Barclays maintains that it tried to post honest assessments in its LIBOR submissions, but found that it was constantly above the submissions of rival banks, including some that were unmistakably weaker.
In its settlement with regulators, Barclays owned up to massaging down its own LIBOR submissions so that they were more or less in line with those of their rivals. It instructed its money-markets team to submit numbers that were high enough to be in the top four, and thus discarded from the calculation, but not so high as to draw attention to the bank.
There is possibility that these vital markets may have been rigged by a large number of banks. The list of institutions that have said they are either co-operating with investigations or being questioned includes many of the world’s biggest banks. Among those that have disclosed their involvement are Citigroup, Deutsche Bank, HSBC, JPMorgan Chase, RBS and UBS.
Investigators are unlikely to produce new evidence against other banks for a few months yet. Slower still will be the progress of civil claims. Actions representing a huge variety of plaintiffs have been launched. Among the claimants are investors in savings rates or bonds linked to LIBOR, those buying derivatives priced off it, and those who dealt directly with banks involved in setting LIBOR.
The extent of the banks’ liability may well depend on whether regulators press them to pay compensation or, conversely, offer banks some protection because of worries that the sums involved may be so large as to need yet more bail-outs, according to one senior London lawyer.
A particular worry for banks is that they face an asymmetric risk because they stand in the middle of many transactions. For each of their clients who may have lost out if LIBOR was manipulated, another will probably have gained. Yet banks will be sued only by those who have lost, and will be unable to claim back the unjust gains made by some of their other customers. Lawyers acting for corporations or other banks say their clients are also considering whether they can walk away from contracts with banks such as long-term derivatives priced off LIBOR.
Facebook Raises $16 Billion at IPO Price $38
May 17, 2012
Facebook Inc. set its final price at $38 a share, as the social network gets ready for its initial public offering on Friday. At $38 a share, Facebook is valued at $104 billion, the biggest-ever valuation by an American company at the time of its offering.
Facebook is set to raise $16 billion from its IPO, becoming third-largest public offering in the history of the United States, behind General Motors and Visa.
On Friday, Mark Zuckerberg, the founder, is set to ring the opening bell for the Nasdaq from Facebook’s headquarters in Menlo Park, Calif., surrounded by executives, engineers and other employees. Shares of Facebook, which will trade under the ticker FB, will start selling to the public later in the morning.
Facebook's final pricing comes amid recent financial disclosures that threw some cold water on the IPO. Last month, the company reported that its first-quarter sales fell 6% from the fourth quarter to $1.06 billion, while profit slumped 32% to $205 million over the same period.
Facebook remains one of the few firms among the recent crop of Internet start-ups making public debuts that is profitable. In 2011, Facebook posted a profit of $1 billion and $3.7 billion in sales, compared to a loss of $56,000 and $272 million in sales as recently as 2008.
At the offering price of $38, Facebook is set to trade at more than 100 times its earnings for the last 12 months. At that level, investors assume the company will be far more profitable than the rest of corporate America. The Standard & Poor’s 500-stock index trades at 14 times earnings. Facebook’s fans believe the rich valuation is warranted, given the company’s prospects for earnings.
Facebook enjoys the highest profile of the recent generation of Web firms, with an audience of more than 900 million users globally, which by itself would make it the third-most-populous nation in the world.
JPMorgan's appalling $2 billion loss
May 12, 2012
JPMorgan Chase CEO Jamie Dimon on Thursday revealed that the banking giant
lost a $2 billion due to a massive trade that went sour, and that the losses
could climb by another $1 billion in the coming days.
J.P. Morgan Chase & Co. told traders several months ago to make bets
aimed at shielding the bank from the market fallout of Europe’s deepening mess.
But instead of shrinking the risk, their complicated bets backfired into losses
of as much as $200 million a day in late April and early May, culminating in the
company’s announcement Thursday of more than $2 billion in losses.
The loss stemmed from a complex deal involving credit default swaps —
insurance-like contracts that essentially allow firms to bet on whether a given
asset will rise or fall. The credit default swaps have been described as weapons
of financial mass destruction. The complicated trading strategy involved
derivatives, financial instruments that derive their value from the prices of
securities and other assets. The bank most likely structured the trade in a way
that magnified losses.
Dimon attributed the loss to "errors, sloppiness, and bad judgment," and
asserted that "we will fix it and move on." But critics of the financial
industry say the loss is more than a mere error, and that JPMorgan is engaging
in precisely the type of risky behavior that brought the financial system
crashing down in the fall of 2008.
In 2010, Congress passed the so-called Volcker rule, part of the Dodd-Frank
Act, to prevent companies from using their own money to make bets using credit
default swaps. However, the Volcker rule has yet to be implemented, and banks
continue to lobby against it. Dimon led the charge in vehemently and loudly
opposing the Dodd-Frank Act, insisting that the near-meltdown of 2008 was a
perfect storm that would never happen again.
The trading losses reverberated Friday, as J.P. Morgan shares fell 9.3%, or
$3.78, to $36.96 in New York Stock Exchange composite trading at 4 p.m., erasing
$14.4 billion in stock-market value. It was the biggest decline since August,
and trading volume soared to its highest level since at least 1984.
How to Estimate Stocks' Fair Values
How do analysts arrive at fair value estimate for a stock, and how do they relate to the stocks rating? To determine a stock's fair value, analysts examine factors such as estimated future cash flow, competitive positioning, and even the degree of certainty the analyst has in making his or her evaluation.
Analysts typically track companies within specific sectors and revise their fair value estimates whenever information becomes available that affects their outlook for a stock. A new product launch, a merger or acquisition, or a major competitor abandoning a market are some examples that could cause an analyst to revise a company's fair value estimate up or down.
The process on how analysts arrive at a fair value estimate is outlined below.
The first thing the equity analyst does is examine the company's fundamentals: sales, revenue, expenses, and so on. These are gathered from financial statements, industry reports, discussions with company management, trade-show visits, and other sources.
Once the fundamental analysis is completed, the analyst proposes a rating of competitive advantage over its competitors for the stock. Analysts propose a moat rating of wide, narrow, or none for a company to determines that rating.
Next, the analyst looks at historical data, along with the company's competitive position and future prospects, to forecast future cash flow. All this data is applied to a proprietary discounted cash flow model to arrive at a fair value estimate for the stock. Due to the specific characteristics of certain industries, special models exist for valuing the industries. This fair value estimate represents what equity analysts believe the stock is currently worth.
Once the fair value estimate is established, the next step is to determine a level of confidence in the estimate, which can vary based on factors such as volatility within the company's industry, economic sensitivity, and other variables that could affect the stock's price in the future. The analyst assigns an fair value uncertainty rating to the stock, which helps determine the margin of safety (or cushion to account for multiple potential outcomes) analysts believe is necessary to recommend buying or selling it. The upper and lower bounds of this margin of safety are determined by a formula that is applied to all stocks based on their uncertainty ratings. A stock with a low uncertainty rating requires a relatively low margin of safety.
The last piece of the process is the rating for stocks, which reflects where a stock's current share price stands relative to fair value estimate. A stock with the highest rating is selling at a deep discount while a stock with the lowest rating is very overpriced. The rating thresholds are also the points at which the recommended Buying and Selling prices kick in. A stock's rating can change daily based on its closing price.
How Index Funds Are Weighted
Different index funds are weighted in a different way. Whatever type of index fund or funds you choose, make sure you understand the methodology, so you can stay away from an investment that doesn't behave the way you expected.
Representing nearly 15% of all mutual fund assets today, index funds have become an increasingly popular choice for investors. The first index fund, introduced by Vanguard in 1976, tracks the S&P 500, and today that index is by far the most popular one used, accounting for about 37% of all index fund assets.
The core premise behind index investing is that beating the market consistently over the long term through actively picking stocks that will outperform is extremely difficult. Instead, the most basic index funds seek to capture the market's performance itself in the belief that the investors who participate in it are fundamentally rational and also value stocks at or near their fair values.
In some cases, if an index is too broad or securities in it too illiquid for a fund to adequately track, the fund's manager might try to mimic the index's performance through a technique called representative sampling.
Although index funds seem to track anything and everything, there are a few primary ways of constructing them, from conventional market-cap weighting to alternative methods such as equal, fundamental, or price weighting.
Cap-Weighted Indexing
By far the most common method of indexing is through market-cap weighting, in which the amount of each stock held is proportionate to its market value, or capitalization. So if a stock's market cap makes up 5% of an index, it also makes up 5% of the fund's portfolio.
The method provides an accurate reflection of how the market looks, with greater emphasis on bigger companies (by cap weight) and less on smaller companies; as stocks grow, they naturally take on a larger percentage of the index without the fund needing to buy new shares, making this method cheaper and more tax-efficient than others.
In rising markets, the index might include a higher percentage of overpriced stocks. The method emphasizes the biggest companies, which might have less room to grow than the smaller companies that make up less of the index.
Equal-Weighted Indexing
All stocks are held in equal proportion regardless of market cap. So, for example, an equal-weighted S&P 500 fund would still include the same 500 stocks as the cap-weighted version, but in equal amounts--in this case each making up 0.2% of the index.
The method provides a greater tilt to midsized companies, which sometimes offer better returns than the largest companies.
By overweighting smaller companies, the index no longer accurately represents the market. The portfolio must be rebalanced periodically--typically quarterly--which creates transaction costs and means the index might fall out of equal-weighting for months at a time. Equal-weighted funds are generally more expensive than cap-weighted index funds.
Fundamental Indexing
Stocks are weighted based on a fundamental metric or metrics, such as dividend yield, earnings, book value, or a combination of factors.
The method can be used to provide a tilt to an index (toward value or income, for example) while generally avoiding the negative effects of stocks becoming overvalued by the market.
Fundamental indexing does not serve as a proxy for the market. It requires rebalancing that can add transaction costs, and funds that employ this method tend to be more expensive than cap-weighted index funds.
Price-Weighted Indexing
Stocks are weighted by the share price for each company in the index, with the Dow Jones Industrial Average the most famous example.
The method requires less trading than equal-weighted or fundamental indexing methods, which helps reduce costs.
The index can become skewed toward overpriced stocks and detached from market values.
