Sunday, September 23, 2012

LIBOR 3: The Good

Unintended consequences can be positive.

As mentioned in the first postings, LIBOR affects consumers in two ways.  On August 3, 2012, the WALL STREET JOURNAL in the Weekend Investor section ran an article entitled "What LIBOR Means for You."  It mentioned the same two ways noted in the first posting on LIBOR.  1) LIBOR estimates affect the cost of borrowing at variable rates.  If the estimates in LIBOR are too high, variable rates are above what the market would justify and borrowers are forced to pay rates that are artificially inflated.  If the estimates in LIBOR are too low, borrowers receive an artificially low rate.  2) LIBOR estimates also affect the returns on savings by reducing the return to lending.
Some consumers may have figured out that by reducing the interest earned on consumer and business loans, an artificially low LIBOR would affect the rate banks to pay on savings.  Some may even have realized that it affects the returns on bond funds.  The article is useful in that it goes beyond that obvious connection.  It points out how the role of LIBOR in pricing derivatives feeds through to the return on savings.  Most consumers are probably unaware of how derivatives affect the return on their bonds, mutual funds and even stock mutual funds.  Unfortunately, it doesn't cover it in detail.  There are, after all, many consumers who would benefit from explicit examples.

However, to continue with “The Good, the Bad, and the Ugly" theme introduced in the second posting on LIBOR, we need some good.  There is plenty of bad and the ugly in the silliness of the LIBOR scandal.  But the good, is more subtle.
There is, however, plenty of good coming out of the LIBOR scandal.  As might be expected, that good is creating some bad and ugly also.  However, first, let's focus just on the good.  On July 30, 2012, the WALL STREET JOURNAL reported on some of the lawsuits related to LIBOR.  The article entitled "New York Lender Files LIBOR Lawsuit" reports: 

In the latest sign of the potential legal vulnerability facing banks ensnared in the world-wide probe of interest-rate manipulation, a New York lender alleges in a lawsuit that it was cheated out of interest income because rates on loans tied to LIBOR were ‘artificially’ depressed.”
“The lawsuit effectively argues that the alleged manipulation short-changed lenders by helping borrowers pay less for mortgages and other loans.”

Without judging the merits of the lawsuit, it's clear that there is an inherent good in finding someone willing to stand up and protest the treatment of savers and investors.  It's also refreshing to see this ribald reenactment of the Christmas classic “It's a Beautiful Life” with a small bank taking on a large bank.  Perhaps the plaintiff will be able to muster the support George Bailey receives from the community.  But even if it is class-action lawyers playing vulture rather than Clarence the Angel, at least someone has taken the side of the small saver and investor.  It, also, doesn't hurt that it's an as politically connected a group as the class-action lawyers who are taking up the cause.
It's important to understand that it is the posture of protesting the shortchanging of savers that represents the good coming out of this.  The merits of the case are a totally separate issue.  A serious look at the actual case is likely to focus one's attention totally away from LIBOR.  The correct focus is taken in a September 16, 2012, WALL STREET JOURNAL opinion piece entitled "Bernanke and the FedRepeal Einstein."

Albert Einstein reportedly called compound interest ‘the most powerful force in the universe.’ He didn't live long enough to experience Ben Bernanke.”
“Last week the Federal Reserve chairman told the world that U.S. savers should expect the new normal of near-zero interest rates to last through mid-2015. So compound interest is a concept with which today's early to mid 20-somethings will remain essentially unfamiliar.”

Perhaps more people will come to realize that it is not banks that set interest rates.  It is the Fed.  If they do, it would serve us well because as the article goes on to state:
“Thrift—that is, work and delayed gratification—is both a personal and societal good. It is supposed to allow us to be self-sufficient in future years, support older generations now, and finance the great engine of progress that has been the American economy. But why save when common instruments such as savings accounts, money-market funds and CDs guarantee that you'll lose out to inflation?”

Courtesy of the Fed, we currently provide no incentive to save.  It is highly likely that it will have to be savers that force a change since the Fed is convinced that it can eliminate all incentive to save without detrimental effects on the economy.  It's a preposterous notion, but then the Fed seems totally oriented toward short run impacts.  That may or may not be advisable, but what is clear is that individuals are beginning to resent the Fed’s financial repression.  So, the LIBOR scandal may have resulted in an awkward way for people to express their resentment of the Fed policy, but at least it gives them a vehicle by which to express it.  That's the good from the LIBOR scandal.


Tuesday, September 18, 2012

LIBOR 2: Regulators Making Fools of Themselves.

If "The Good, The Bad, And the Ugly" were the title for the LIBOR farce, what is this?

Ultimately the craziest thing to come out of the LIBOR scandal is the posturing of the central banks.   However, to understand how disingenuous some of their statements are one must look beyond the current scandal.  What is particularly odd is the extent to which some banks are pretending that LIBOR only became an issue when the scandal began.
The truth is that most regulators knew many of the deficiencies of LIBOR well before the scandal began. To some degree, there was a divergence of responses. Some wanted to do something about the perceived deficiencies. Others felt that they probably couldn’t do much better. The bottom line separating attitudes boils down to how tightly the regulators want to be able to manipulate interest rates. 

Consider this little piece from the WALL STREET JOURNAL (July 20, 2012) entitled: “Bank of England Repelled Tougher Libor Oversight.”  The article states: "… disclosures seem to vindicate the argument made recently by the Fed that it was out front on the issue, a story line Mr. King [speaking for the BOE] has sought to rebut. In another email to Mr. Tucker from June 2008, William Dudley, a Fed official who later would become president of the New York Fed, said, "I understand the BBA is going to have a better policing regimen…but the governance still sounds a bit weak."
“In its statement, the Bank of England referred to a memo then-New York Fed President Timothy Geithner sent to Mr. King that discussed, among other things, ways to eliminate incentives for banks to misreport Libor submissions. ‘The Geithner memorandum contains no allegation of wrongful behavior,’ the Bank of England said in the statement.”
It is worth noting that the Fed, or perhaps the Treasury, clearly achieved a very high profile PR placement by having this article appear.  However, if one looks closely at what the article actually says, the Fed appears in a very different light.  Basically, the article states that the Fed accused the Bank of England of not monitoring the potential for manipulation of LIBOR.  The Bank of England respondent by pointing out that the Fed provided no evidence other than that there might be an incentive to manipulate LIBOR.  The Fed’s warning may seem very timely in light of subsequent developments.  That would undoubtedly be the case if it had been original.  However, the Fed is claiming authorship that clearly is undeserved.
To understand just how disingenuous the Fed’s posturing is consider the following story that appeared in the same newspaper, the WALL STREET JOURNAL, on September 11, 2011.  The article entitled “Before Scandal, Clash Over Control of LIBOR” was only the most recent of a number of articles reporting on controversies surrounding LIBOR.  However, it makes the Fed’s posturing appear as ridiculous as it is.  In that respect, it does a definite public service.  When public officials say things that are clearly intended to mislead, their statements should be juxtapositioned against the actual facts.  In this case, the facts are, as the article points out, “At an April 25, 2008, meeting with officials at the Bank of England, Angela Knight, head of the British Bankers' Association, argued that the London interbank offered rate, or LIBOR, which serves as the basis for interest rates on trillions of dollars of loans and financial contracts, had become too big for her organization to manage, according to minutes of the meeting and a person who was there.”

Put bluntly, controversy surrounding LIBOR had developed well before the Fed seemed to recognize it.  It had developed to the point that the British Bankers’ Association had admitted things were beyond their control three months before the Fed claims to have discovered that banks may be guessing incorrectly about their potential cost of capital.  If one looks closely, one realizes that from the very first indications of financial market malfunctioning, analysts were noting that LIBOR wasn't accurately reflecting interbank credit markets.  Further, interbank rates didn't reflect credit market conditions.  However it would be embarrassing for regulators to honestly describe their reactions.
What is more significant than the differences in reactions between regulators is the changing reaction of both regulators over time.  Nowhere is that sillier than in the posturing regarding the current scandal.  The Fed would have us believe that the problem was, and is, the difference between their attitude toward LIBOR versus BOE's.  The truth is that both regulators changed their positions significantly between the periods before and after they saw the scope and severity of the financial crisis.  Further, the changes were more or less the same both at the Fed and at the BOE.

One should remember a bit of terminology that was introduced to the public during the prelude to the most severe developments of the financial crisis.  TED spreads are economic shorthand for the difference between T-bill rates and short-term interbank offering rates (i.e., LIBOR).  Throughout 2007 TED spreads were increasing.  The increase became dramatic as LIBOR failed to mirror any changes in T-bill rates.  By June of 2007, a year before the Fed's correspondence with the BOE and nine months before the British Bankers’ Associations meeting with the Bank of England, the behavior of TED spreads clearly pointed to major financial problems.
It's useful to remember what the regulators’ reaction to the TED spread was.  As the regulators lowered rates and LIBOR failed to follow, in typical regulator fashion, they blamed the messenger.  In this case, it was the failure of LIBOR to fall.  There was considerable speculation among regulators that bankers were intentionally manipulating LIBOR to keep the LIBOR rate high.  It never occurred to regulators that, in fact, there was a liquidity crisis developing. 

In hindsight, it is apparent that the bankers were right.  It cost them dearly to attract more capital.  In fact, many of them had to give up control of their institutions.  It's also worth noting that this charge is the opposite of the current scandal.  The current scandal is based upon the assumption that banks artificially kept LIBOR low in order to make themselves look financially healthier than they were.
It has never occurred to the regulators that perhaps the problem is that their continued manipulation of interest rates has totally eliminated any information content LIBOR may have once had.  It's quite reasonable to argue that no one can be faulted for misrepresenting their borrowing costs in an environment where their borrowing costs are not determined by the market.  Guessing what rates will be in the market is fraught with all sorts of problems, but guessing what policy changes will be made that will change borrowing costs is impossible in an environment where the regulators’ behavior is totally erratic.

The silliness of the posturing becomes even more apparent when one reviews the content of various postures the regulators have taken.  This may sound like “the gang that couldn't shoot straight,” but it's nothing more than a review of some historical facts.  Because it's based on what actually happened, I've reproduced a chart showing the long-run behavior of TED spreads.  They demonstrate the relationship between Treasury interest rates and LIBOR.  The chart was taken directly from Wikipedia.  It shows the long-run relationship in order to demonstrate that normally LIBOR and Treasury rates track each other fairly well.
That tracking, however, is not immediate or perfect.  That can be seen when looking at the periods before the financial crisis.  During the financial crisis, however, regulators seem to have expected the tracking to be instantaneous and perfect.  Whenever it wasn't, charges of manipulation surfaced.  Now there may or may not have been collusion, but the point is collusion was totally unnecessary to explain the fact that Treasury rates and LIBOR rates do not track perfectly.

Regulators showed a total disregard for the potential for temporary deviations in the path of LIBOR and Treasury rates.  During 2007, Treasury rates were being forced down and LIBOR did not immediately respond.  In response, the banks were accused of artificially inflating LIBOR.  Supposedly, they did this by not bidding for other banks’ loans in the interbank market.  The charge was that they were doing this in order to keep the return on their variable rate loans high.  That would all seem feasible. 
That charge contradicts the regulators’ assertion that the financial crisis was developing because banks had intentionally making bad loans.  Supposedly the banks could make the bad loans because they did not have skin in the game.  It never seemed to phase the regulators that if the banks didn't have skin in the game, they didn't have the incentive to keep LIBOR high.
The posturing became a shrill cry about midyear when bank regulators panicked and sharply reduced borrowing rates.  LIBOR initially spiked.  The regulators action was justified.  It was the correct response to a financial crisis that threatened a complete locking up of financial markets.  The posturing was not justified.  The bankers’ response was also totally appropriate.  As was amply demonstrated, banks that were able to preserve their capital were able to avoid needing bailouts from the regulators.

If one looks at the data, it's very hard to figure out when during the financial crisis the behavior of LIBOR relative to Treasury rates would suggest that LIBOR was artificially low.  In fact, the gap between the LIBOR and Treasury rates (the TED spread) remained elevated well into the financial crisis. 


To charge banks with wanting to make themselves look financially healthy is a layup shot for regulators.  There isn't any doubt that corporations want to look financially healthy.  Submitting false data in order to inflate the appearance of financial health is a serious crime.  Perhaps it would be better to say that previous to the nonsense that has accompanied the financial crisis it WAS a serious crime.  Using the charge to shakedown an organization or court the publics’ support makes a joke of the charge.  The regulators have turned serious charges into a farce.  By so doing, they have seriously damaged transparency as well as their own creditability.

Sunday, September 9, 2012

LIBOR 1: Scandal! Or, Is It?

The news as farce.
One can’t follow the LIBOR “scandal” without thinking that perhaps you’ve fallen through the looking glass. If you understand why, you should be singing Gnarl Barkley’s version of Crazy.

To start, one suspects that many of those who are scandalized do not know what LIBOR is.  So, let’s start with a quick definition.
Basically a bunch of big banks estimate (guess) what they would have to pay to borrow for various periods of time if they were willing to borrow and if they were borrowing in a well-functioning credit market. For those who want a more complete and technical definition, an excerpt from the Wikipedia definition is included at the end of this posting.

It seems many people who comment on the scandal either ignore the definition or can’t distinguish its important features.  They get hung up on the fact that banks are involved.  They miss the fact that it’s a guess about what the banker could do if the banker lived in a fictional world of well-functioning markets.   The lawsuits surrounding LIBOR reflect just how absurdly the efficient market theory (EMT) has permeated the thinking of market non-participants.

Actually EMT is received wisdom when we’re talking about market non-participants.  They can’t conceive of a world where EMT doesn’t apply.   Yet, to understand the silliness of the LIBOR scandal one must discard EMT completely.   It’s folly to judge behavior that can only be assessed if there is a well-functioning market when the behavior occurred at a time when a well-functioning market didn’t exist: put bluntly, the markets weren’t there.  There was a liquidity squeeze going on. 
The foolishness is highlighted by the absurdity of thinking banks conspired.  Clearly, the herd was in control.  That’s what produced the liquidity squeeze in the first place.  A herd doesn’t need to conspire.  It’s a herd for goodness sake! The absurdity of the conspiracy charge simply ignores how herds function.  It is individuals each acting in their own perceived self-interest that produces the herd.

Nevertheless, the courts will proceed by constructing their own private (and it might be noted case-specific) counter factual.  They’ll have to guess what a well-functioning market would have looked like.  Only then can they decide if each bank’s behavior, that is its guess, is consistent with the court’s fictional well-functioning world.  They want us to believe that this financial equivalent of fantasy football will result in justice.  Who are they kidding!  Let’s call a shakedown a shakedown. 
Another absurdity is that one branch of government, the judiciary, is assuming it should ignore the fact that another branch of government, the executive, was proceeding on the assumption markets had broken down.  A consistent approach would be to throw out any suits that require a different reality where well-functioning markets had existed.  Alternatively one could impeach the executive branch for pretending markets had broken down.

Just for fun, let’s assume every bank fudged its estimate to reflect its perceived self-interest.  That is not an unreasonable assumption.  Acting in their own self is, after all, the charge behind Barclays Bank’s settlement.  Could such behavior bias the trimmed mean average estimate called LIBOR?  Only if a large number of banks had the same perception of their self-interest.  That also seems like a reasonable assumption.  As far back as 1776, Adam Smith pointed out the danger of industry-wide common interests as a part of his rationale for competitive free trade. 
However, looking closely at the roll of LIBOR raises some serious reasons to set a very high requirement of proof of a common interest.  To understand why, consider how LIBOR is used.  Two major uses are 1) to set the rates on many variable rate consumer and business loans, and 2) to establish the payouts and thus the value of many credit derivatives.   

The current charge is that banks systematically underestimated what their borrowing cost would have been if a market had existed.  During the financial crisis that underestimation made LIBOR appear lower than it should have been.  Given the charge behind the scandal, it’s reasonable to dismiss the first use of LIBOR as a justification for the alleged conspiracy.  There haven’t been any convincing arguments supporting the idea that bankers benefit from artificially low interest rates on consumer and business loans. 
The second use of LIBOR, as a standard for many financial derivatives, does raise issues.  It also raises some doubts: for there to have been a common perceived self-interest, there would have had to have been a common net position regarding the derivatives.  Not only is that unlikely, it is probably impossible. 

In the derivative markets, it is often banks that end up holding both sides of the trade.  To illustrate, one bank may be strong in credit cards or HELOCs.  It may feel it’s prudent to swap (or hedge) some of its variable rate loans for a fixed rate asset.  Another bank may be strong in traditional fixed rate mortgages and want to do just the opposite.  When the banks have operations in different countries such differences can result from something as simple as the borrowing customs in different countries.  Interest rate SWAPs are a classic derivative. Compound that by multiple currency exposures that banks may want to swap or hedge.  Add durations, industry or company exposures, etc., and it isn’t surprising that many derivative trades are ultimately between banks.
While a common interest may exist, it certainly doesn’t originate from derivative trading.  Derivative trading is more likely to create conflicting interests.  So, let’s look elsewhere. 

Reportedly the charge in the Barclays settlement is that they intentionally underestimated what their cost of borrowing would have been.  The charge was they did this to make banks and their bank look healthier by influencing the price of derivatives called default insurance.  Now that seems quite reasonable. They tried to make themselves look good.  What business, union, government agency, or individual doesn’t?  When it’s done to influence a financial market it can be a serious crime.  In fact, we have numerous regulations to prevent it. 
However, here’s the problem with the conspiracy theory.  Why would other banks want Barclays or the banking sector in general to look good?  Were they all insuring Barclays’ debt?  Not likely.  To drive home the fact of inconsistent interests, consider whether JP Morgan had an interest in Bear Sterns looking good before they acquired it?  How about WAMU?  Did Wells Fargo want Wachovia to look good? 

Barclays may well have arrived at an intentionally biased estimate.  They may have conspired within the bank or even gotten other banks to cooperate.  They may have known that their estimates weren’t what they would have been able to do if they had tried to borrow in a well-functioning market.  However, no realistic judgment is possible without hypothesizing what a well-functioning market would have looked like, and the terms Barclays would have agreed to.  More likely, Barclays just decided that they just couldn’t win this game of fantasy football and settling made more sense.  We’ll never know.  What we do know is that proof only exists on the other side of the looking glass.
The real wonder concerning the LIBOR scandal is the self-contradictory posturing of bank regulators.  That’s the topic of the next posting on LIBOR.  Finally, what will hopefully be the last posting will discuss the good that could result from the whole farce. 

“The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.”

“This definition is amplified as follows:
  • The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market.
  • Contributions must represent rates formed in London and not elsewhere.
  • Contributions must be for the currency concerned, not the cost of producing one currency by borrowing in another currency and accessing the required currency via the foreign exchange markets.
  • The rates must be submitted by members of staff at a bank with primary responsibility for management of a bank’s cash, rather than a bank’s derivative book.
  • The definition of “funds” is: unsecured interbank cash or cash raised through primary issuance of interbank Certificates of Deposit.
The British Bankers' Association publishes a basic guide to the BBA Libor which contains a great deal of detail as to its history and its current calculation….”

“The London Interbank Offered Rate is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is usually abbreviated to Libor ( /ˈlbɔr/) or LIBOR, or more officially to BBA Libor (for British Bankers' Association Libor) or the trademark bbalibor. It is the primary benchmark, along with the Euribor, for short term interest rates around the world….Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor. Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor.”