It’s useful to think of the financial system as a pyramid, with each layer preying and manipulating the layer underneath it. Each layer up the pyramid is wealthier and generally savvier than the layer below it, and generally the manipulation of the lower level becomes more complex. We’ve briefly talked about this before here, but it’s useful to visualize an example: at the bottom of the pyramid are the poorest players – working people, not very financially literate, who are very easy to manipulate:

Like this, for example...

These are the folks who are preyed on by the payday loan people, or who are willing to pay $1,949.22 for an $700 Ipad.

As you go up the pyramid, though, the manipulations become a lot more subtle. At the heart of the pyramid are the large investment banks, and their favored prey is the famed “retail investor”, the wealthy dentist or vice president of sales that have enough income to save it and invest it in the stock market.This is the gazelle of the financial world: tasty, plump, and completely clueless about the market that they invest into.

"Do I have a stock for you!"

The fundamental problem of the retail investor is that he simply doesn’t know enough about the companies that he is investing in to understand them, but he is buying and selling them from intermediaries who do. For example, remember the bubble? The gigantic crash of internet stocks in 2001?

Spot the bubble. Hint: it looks like a pyramid.

The crash in 2001 was catastrophic because millions of retail investors (gazelles) had gotten into the stock market because of the incredible growth of Internet stocks. Tired of seeing everyone else making money at incredible rates, the retail investors started to pile into the Internet stocks, only to see their value completely collapse over a couple of years. But how did the bubble start? How did the Internet stocks begin their dazzling growth to begin with?

The key here was the banks that took these companies public. The banks knew that the Internet stocks they were hawking had very little chance of ever becoming profitable, but they couldn’t give up the fees for taking these companies public. So they invented a new technique: laddering.

Laddering is a simple concept. If you’re Merrill Lynch, for example, and you’re taking a company like Webvan public, how do you make sure that Webvan shares go up in value after you take them public? You basically offer some shares to your best clients, but in return for getting the valuable Webvan shares (almost guaranteed to appreciate!), you ask them for a simple thing: a promise to buy some more shares a few months (or weeks) later, at a significant markup. The clients buys the shares, because they know that they will likely go up, and even thank Merrill for the chance to get in on a ‘sure thing’. Now, Merrill has essentially achieved three things: it has placed the shares offered on IPO; it has ensured, thanks to the promises made, that the stock would go up like a rocket post-IPO. And it has increased its reputation as a bank that makes great IPOs, which will make attracting the next Internet company easier and selling the next ladder even easier.

The practice was eventually outlawed, and Goldman Sachs, one of the worst offenders, paid a $45M fine for it eventually. But the practice worked long enough for the banks to fleece a gigantic amount of money from the retail investors, both in fees and in calculated trades that were possible since the banks essentially knew the price curve for the stock post-IPO – they had designed it through the ladder mechanism.

There are dozens of different ways to fleece the retail investors, and we’ll continue to explore some of them on the blog. But to get to some of the really interesting manipulations, we have to climb the pyramid a few rungs, beyond the simple I-banks and mutual funds and even might Goldman Sachs. Much higher on the pyramid (but not at the top yet) are those that prey on the banks themselves.

One such manipulation became public this week. Have you ever heard of LIBOR?

LiBor. LiBor with a B. Pay attention, please!

Libor is an important rate. It stands for the London Inter-Bank Offered Rate, and it is the rate set each day for banks to lend to each other. It is, effectively, the rate at which the best non-government entities can borrow from each other. Why should you care, if you’re not a bank?

Well, it turns out that Libor is the benchmark for trillions of dollars of financial products. Since Libor represents the best commercial available rate of borrowing, it has become customary to set up thousands of financial instruments, from mortgages to credit default swaps to credit cards to deposit interests. All of these instruments are priced at some premium to Libor. Trillions of bonds are trading today, for example, at markups of Libor. It is the international equivalent of the Fed T-bill rate here in the US, and arguably even more widespread than the Fed rate since it is international.

Most financial professionals (the guys higher-up in the pyramid) know the Libor rate every day, but few stop to think about how it is actually set. Libor is actually set in a unique way: every day, at 11:00am, in London, ten panels of bankers meet for 45 minutes. Each panel deals in one specific currency, from dollars to yen, and the bankers decide at what rate they are willing to lend money to each other. When they emerge, the rates are communicated to the rest of the world, and Libor is set that day.

This is why the meeting is at 11:00am.

For most of the finance professionals in the world, Libor is a background process that they never think about – we all know the weather every day, but how many of us think about the ways in which the clouds and the air masses interact to form it?

This gave an idea to some savvy traders at UBS. If someone could know what the Libor rate would be before 11am, that would be a tremendous advantage: you could trade securities from mortgage to bonds, knowing which way the Libor rate would move, and make guaranteed profits.

But how would you know the rate before it was set?

The traders at UBS knew some traders at other banks. Specifically, those at JPMorgan, Citigroup, HSBC, Deutsche Bank, and RBS. All of these banks are on the panel that sets Libor in the Japanese yen denomination. So the traders called each other, and then called their rep on the panel. Together, they agreed on which direction the Libor should move, and, magically, when the panel met, the rate was set as discussed.

"We are agreed, then?"

This was an impressive manipulation. It was completely transparent – there was no way for traders not in those institutions to know that the yen Libor rate was not set ‘properly’, based on fundamentals, but by manipulation. And changes of a few basis points, or less than 1%, could still net traders huge profits because of the size of the contracts involved. In many ways, this was a great textbook manipulation.

Was it illegal? Time will tell (this just came to light a few days ago), but this will not be easy to prosecute. Traders and index bankers are not supposed to collaborate, but that is more of a guideline than a set rule, and depending on how exactly the traders communicated it may be very hard to show that anything illegal happened. This, of course, just makes the manipulation that much more sophisticated.

The victims of this manipulation were fairly financially savvy. They were traders at major institutions, knowledgeable and with access to the best financial information in the world. In pyramid terms, they were fairly high up on the pyramid. And yet, there were people above them in the pyramid who made a great living by preying and manipulating even those high-ups.

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Of course, this metaphor begs the question of who or what is at the top of the pyramid. To some extent, it’s hard to remain anonymous at the very top. Folks like JP Morgan himself, who used his powers of influence and manipulation to stop a financial panic in 1907 by forcing over 140 bankers (and the US government) to abide by his plan. Or George Soros, who broke the bank of England, both belong there. The skill required to manipulate successive layer rises as you go up the pyramid, and few have the skills required to manipulate the very top layers of Goldman Sachs and others of that ilk.  The reality is that the very top of the pyramid rotates frequently: after all, it is an increasingly dangerous game to play as you go up, but of course the rewards are proportionate…