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.”

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