Ex-Derivatives Trader: How I Messed With LIBOR (And Lived)

From Boston Review: “…The occasion of my transgression was a client’s request for an unusual (to my eyes) custom financial structure. “This trade has been around forever,” the client said about the proposal, a tax trade. “The government keeps shutting it down and people keep figuring out ways to make it work again.” And the client thought that it could be made to work yet again if we—Citigroup—could figure out how to structure the transaction to fulfill their litany of requirements.

Based on our discussions, I set about working on a presentation that I christened “Tax Transaction.” This draft was met with horror by my managing director since, he informed me, “Tax transactions are illegal.” So the presentation was rechristened “Alternative Financing Discussion,” the structure was given a purely economic justification, and taxes, when referenced, were discussed in a deliberately offhand manner signifying tertiary concern (e.g. “This method of financing is also more tax efficient than other methods of financing”).

In this alternative financing method, the client would effectively borrow money at a fixed rate. To justify using a fixed rate we needed to show it could be cheaper for the client than borrowing at a floating rate. This justification was part of the economic purpose we had given the deal. It did not matter that this transaction’s fixed rate was higher than the fixed rate the company could actually get on the open market (a loss the company didn’t care about since it would be dwarfed by the expected tax savings the deal would bring). The only thing that mattered was whether we could somehow create a scenario where borrowing at floating rates, i.e. rates pegged to LIBOR that reset every few months, would end up being more expensive than borrowing at the fixed rate built into our “Alternative Financing Transaction.”

So as I set about figuring out how the bank could structure the transaction in a way that satisfied both the client’s criteria and our internal bank policies, I also began making up future LIBORs. I say “making up,” rather than “forecasting,” because I was not really trying to forecast anything. Every few days or weeks I’d look at interest rates, figure out what the fixed rate in the transaction would end up being, and then see if, without being completely outlandish, I could come up with different combinations of future LIBORs …..

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