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.

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