One would think that at some point the media would
realize it has already beaten the dead horse to death. However, even the WALL STREET JOURNAL is
prone to falling into the trap of trying to make news out of a dead issue. Granted, LIBOR is not a dead issue, but it's
one that the media is unable to cover in a technically meaningful way. As consequence, they end up saying the
absolute silliest things. On September 28,
2012, the WALL STREET JOURNAL gave major coverage to an article entitled "LIBOR Furor: Key Rate Gets New Scrutiny.” But the subtitle for the article points out
just how far the media is stretching to keep this story alive. The subtitle was "Banks Often
Don't Change the Quotes That They Submit."
My initial reaction
was "Well da! Hasn't the Fed been
holding interest rates unchanged for some time now? Why would anyone expect banks not to
appreciate that the Fed will hold borrowing costs fairly stable?" Given the silliness of the entire issue, the
article becomes worth reading in order to understand how reporters get
themselves so confused.
When one does start
looking at the article, it becomes an even stranger report. The first thing strange is the shifting and
ill-defined timeframe that is the focus of their concern. The article states:
"From the
start of 2012 through the end of August, the 18 banks on the main U.S.-dollar LIBOR
panel left their daily estimated rates unchanged on average 87% of the time,
according to the analysis of data from Thomson Reuters Corp. and S&P
Capital IQ.”
Between the start
of 2012 and August, one might wonder when that 13% of the time when the
estimates changed occurred. Interest
rates just did not fluctuate during that period. So it's worth investigating how the reporter
arrived at this twisted logic. It is a reputable paper so it's reasonable to
assume that it wasn't just to fill space.
There had to be some logic, and the article goes on to explain that
logic. It goes on to state:
"For around a
third of the banks, there was only a weak to moderate correlation—if
any—between their LIBOR submissions since January 2009 and the rates on their
one-year credit-default swaps, or CDS, which insure against the risk of the
firms defaulting. Banks, for their part, argue that there are valid reasons why
CDS prices may behave differently from LIBOR."
The first thing to
note is that the timeframe has changed.
We're now talking about since January 2009. However, what is stranger is that the
reporter clearly believes that the CDS market is somehow more reflexive of what
the market rate should be than Fed guidance.
Put bluntly, this either represents an absurd assumption about the
efficiency of markets or reflects a significant distrust of Fed
statements.
Further, it ignores
the institutional framework that surrounds the CDS market versus the actual
lending market. CDS’s can be used in a
variety of ways, not the least of which is hedging the tail risk implied by
actual loans. One would not expect the
return or payment from an individual insurance policy to represent the
individual policy’s premium cost. The
purpose of insurance (such as CDS’s) isn't to get back your premiums. It's to lay off certain risks.
The conditions
under which the underlying assumption of the logic that the CDS market and the
actual lending market should be highly correlated require eliminating from
consideration all use of CDS's other than as a way to make money. If 1) the purpose of all CDS transactions and
the purpose of all loans are to make money, and 2) people making the CDS
transactions and the lending decisions have the same risk profiles, and 3) the
leverage implications of the CDS are similar to those of the loan, then, and
only then, would one expect a high correlation between the CDS market and the
lending rates.
Clearly, not all
CDS transactions are intended as a speculation that will make money. Some are, in fact, insurance against a
particular risk made with the hope that there will never be a payoff. So, the first necessary condition is not
met. It would be incredibly naïve to
assume that the risk tolerance of people buying and selling CDS's are the same
as those taking out or making loans. So,
the second necessary condition for the whole argument to have any merit is
violated. Finally, anyone who has ever
used an option knows that it has different leverage implications from an actual
long or short position. So, the third necessary
condition, also, isn't satisfied.
It's important to remember that it is only for
"around a third of the banks" that "there was only a weak to
moderate correlation." So, for
about two thirds of the banks, there was more than a moderate correlation. Given the multiple uses to which one could
put a CDS if one were a bank, that seems like a very reasonable portion.
Most of the balance
of the article consists of quotes from various authorities that a reporter
feels are supportive of his thesis.
Consequently, the balance of this posting addresses each of those quotes
in turn. They can be skipped by anyone
who can see the flaw in the logic of the article.
The first of those
quotes is from Andrew Lo.
“There's a concern
that if you're going to base financial decisions on a particular interest rate
it should be a measure that responds to changes in market conditions, and
that's not LIBOR.”
This quote is the
reason that the article being discussed was written on September 28 and this
posting isn't being made until late in October.
Andrew Lo is no lightweight when it comes to understanding financial
markets. The Hedged Economist has
referenced his work as summarized in A RANDOM WALK DOWN WALL STREET. One suspects that his quote has been taken
out of context because the general thesis of A RANDOM WALK DOWN WALL STREET is
that markets are not totally efficient in the sense of conforming to the
stronger form of the efficient market hypothesis. Thus, the low correlation between lending
markets and credit default swaps should not be surprising.
Nevertheless, the
quote from Andrew Lo caused me to postpone posting this discussion until after
I had been able to work through the mathematics and prove to myself that
mathematically, there is no reason why credit default swaps and LIBOR rates
should be correlated. For them to have
high correlation one would have to believe that the distribution of the
probability of collecting on a CDS is the same as the potential loss from a
default on the total loan to the banks involved.
Even if one is
willing to make the oversimplifying assumption that the probabilities
associated with both are normally distributed, it seems unreasonable to assume
that they have the same distribution.
Further, in fact, mathematically, the distributions are not normal. Both distributions are leptokurtic with a
negative skew. No one could reasonably
argue that the kurtosis and the skew are the same on both distributions. Yet, mathematically those are the conditions
that have to be met. So, not only is
there a logical institutional reason that one would not expect LIBOR and CDS
markets to be perfectly correlated, mathematically, it can be shown that the
conditions under which they would be highly correlated don't exist.
It took some time
to work through the math, but I'm comfortable with the statement that it's
totally unreasonable to expect a high correlation between LIBOR and CDS’s. Andrew Lo’s comment, however, is just fine. There is absolutely no reason that credit
default swaps should be priced based upon LIBOR. LIBOR and the credit default market are
measuring different phenomena.
The next quote
includes some statements that quite frankly don't make sense without
substantial justification that isn't provided. Darrell Duffie, a finance
professor at Stanford University, is quoted as follows:
“One would expect LIBOR
submissions to change frequently if the rate reflected accurately what it's
supposed to measure.”
The problem is that
Professor Duffie doesn't define what he thinks LIBOR is supposed to
measure. That isn't a difficult question
to answer, and if one accurately answers it, his next statement doesn't make
sense.
“This year's frequent ups and downs in credit markets
mean each bank's LIBOR submissions could be expected to change ‘most days.”
Again, Professor Duffie doesn't
indicate what credit markets he's referring to.
If it is the credit market for interbank borrowing, which is what LIBOR
supposed to represent, there clearly was an anchor that precluded frequent ups
and downs in short run interest rates.
So, he's referring to a market other than the one LIBOR measures. It is highly likely that he is focusing
instead on LIBOR’s use in the CDS market.
But that's a use of the rate not what the rate is supposed to
represent. As Andrew Lo pointed out, the
use may be inappropriate. That does not
mean that LIBOR was wrong. It may have
been wrong, but the data Professor Duffie sites
is totally irrelevant to that issue. He
then goes on to point out the stability in the rates as if that were an
indictment:
“Instead, banks leave their rates unchanged most of the
time. The analysis shows the number of submissions that stay the same from
day-to-day has shot up since the financial crisis, with some firms leaving
their estimates unchanged for months on end.”
Curiously, he then points out why LIBOR shouldn't be
expected to change much from day-to-day.
“There's not a
great deal of new information for banks to use each day”
He then goes on to
point out what he thinks is responsible for the absence of changes day-to-day
even after he's presented the reason.
“Instead, their
herd instincts take over and they tend to avoid changes that could make them
stick out from the pack.”
The hollowness of
that argument is reflected in the fact that, for the majority of banks, there
was correlation between their LIBOR submissions and the credit default swap
market. As stated above in this posting,
it's about the right portion. But it's
the correlation not the volatility that's relevant.
The next quote is
interesting. The periods being referenced
change dramatically. It involves a
comparison of 2005 and this year. In
2005 there was considerable uncertainty regarding what would be done with
interest rates. One might remember that
there was discussion of the potential that interest rates needed to be raised
in order to cool the housing bubble. The
discussion was public and often took place at the Federal Reserve Board
meetings. Given that one would expect
LIBOR to fluctuate more in 2005 than it did in “the last year.” That's exactly what the quote shows.
“Banks on the
three-month U.S.-dollar Libor panel on average left only 29% of their
submissions unchanged in 2005, compared with 75% last year and 87% this year to
the end August, the analysis shows.”
The final quote and associated comment are spot on.
“There are a number of factors
that can affect movements in CDS prices, meaning they shouldn't necessarily go
in exact lock step with LIBOR.
But
Raghu Sundaram, a finance professor at New York University, said he ‘would
expect a degree of co-movement’ between LIBOR submissions and CDS spreads, as
stress on a bank should increase both.”
One
can't argue with Professor Sundaram, but the issue is how much co-movement, and,
as stated above in this posting, the co-movement seems to be about right given
the fact that there are as many factors as there are that affect lending rates
and CDS’s differently.
Interestingly,
the article concludes with a response from HSBC and French banks that seems to
indicate that they have a good understanding of how their borrowing rates
interact with the CDS market in general.
What's
really strange about this sorry effort to find malfunctioning in LIBOR where
there wasn't any is that clearly, there were periods when LIBOR markets weren’t
functioning. Interbank lending was
frozen along with much of the financial system.
However, as discussed in "LIBOR 1: Scandal! Or Is It?” the problem with the period when
LIBOR wasn't functioning is that it doesn't provide much support to the scandal
mongers.
The September 28, 2012 article discussed
above was accompanied by one entitled “U.K. Unveils Plans For LIBOR Overhaul.” One might expect a lengthy discussion of
their overhaul plans. However, what they
do is far less important than that they base it on a realistic assessment of
the situation they're facing. There is
no doubt that if they can divorce themselves from the political and public
relations impact of their decision, they are perfectly capable of developing
effective changes.
My only comment is that the discussion in the
article doesn't provide an encouraging summary.
For example, reference to removing the British Banking Association’s
role in setting LIBOR is presented as if it's a punishment for the role of the
BBA in the scandal. Since the BBA was
one of the first organizations to express concern about LIBOR and to indicate
that they felt it was too important to be left in the hands of the BBA, one
suspects the whole issue is going to be played for the bleachers rather than to
improve financial markets.
A few weeks after these articles appeared in
the WALL STREET JOURNAL, there was another article that made reference to the
fact that a banker, had pleaded guilty to encouraging his staff to make this a submittal
that would reflect well on their back.
That represents effective reporting.
Trying to manufacture a scandal doesn't.
No comments:
Post a Comment