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Why the LIBOR Scandal Matters: ‘Destruction of Confidence to the Nth Degree’

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The LIBOR-rigging scandal that has engulfed London in the past week is now lapping at America's shores.

On Monday, an oversight panel of the House Financial Services Committee sent a letter to the New York Fed asking for transcripts of phone calls between Fed officials and Barclays (BARC.L) executives from 2007 and 2008, The New York Times reports.

At issue is whether the NY Fed ignored reports of irregularities in the LIBOR market during the financial crisis, as U.K. regulators are alleged to have done. (According to Reuters, the Fed knew of irregularities in the LIBOR market as early as August 2007.)

The bigger issue here is that LIBOR is at the very heart of the financial market and if you can't trust LIBOR, what can you trust?

"LIBOR is probably the single-most supposedly market-based price of credit in the world," explains David Kotok, CIO of Cumberland Advisors. "And now we see it may have been rigged and rigged for a long period of time. It's destructive of confidence to the 'nth' degree and calls into question huge elements of finance."

I know this is wonky stuff for people who aren't familiar with the jargon, but LIBOR is big. Really big. Finding out it's been rigged is like finding out Greenwich Mean Time is off. (See: LIBOR Scandal Latest Sign of Financial System's Rotten Core)

LIBOR -- officially the London Interbank Offered Rate -- is the rate at which banks will lend to other banks. The Commodity Futures Trading Commission estimates over $800 trillion of financial instruments are pegged to LIBOR, including $350 trillion in swaps and $10 trillion in loans, including mortgages and auto loans, The WSJ reports.

"If you can't trust what is believed to be a market-based price, then you have to question all market-based prices," Kotok says, suggesting their could be massive lawsuits against financial institutions and regulators "because we now know the price-reference was rigged."

To date, most of the attention over the LIBOR scandal has focused on Barclays and U.K. regulators. On Monday, Bank of England deputy governor Paul Tucker faced tough questions from U.K. Parliament after Barclays executives suggested he condoned LIBOR manipulation. (Tucker denied wrongdoing but when asked if the LIBOR market was still rigged, he confessed: "I can't be confident of anything after learning of this cesspit.")

But Kotok notes Barclays is designated as one of the Fed's primary dealers, the select firms that trade directly with the U.S. central bank.

'Failure After Failure'

In the early 1990s, the Fed suspended its surveillance of primary dealers, another example of Alan Greenspan's laissez-faire approach to regulation. Since then, there has been "failure after failure" among their ranks, Kotok notes, citing Lehman Brothers, Bear Stearns, Merrill Lynch, MF Global, Countrywide, and now Barclays.

"What kind of supervision and regulation do we have of the most important entities that deal with our own central bank?," he wonders. "If you can't trust the regulatory authorities, who are supposed to be protecting investors, institutions and participants, then who can you trust?"

As noted here yesterday, Kotok expects "more ugly revelations" to come out of the ongoing investigations, on both sides of the Atlantic, of alleged LIBOR manipulation. Last week, Barclays paid roughly $450 million to settle charges by U.S. and U.K. regulators that its traders had manipulated LIBOR. Most observers believe Barclays is just the first firm to settle; global regulators are investigating more than 10 other big banks, including UBS (UBS), JPMorgan (JPM) and Citigroup (C), according to The Times.

"This is the beginning, we are only opening and peeling off this onion," Kotok says.

Stay tuned for continued coverage as develops warrant.

Aaron Task is the host of The Daily Ticker. You can follow him on Twitter at @aarontask or email him at altask@yahoo.com