Wednesday, October 24, 2012

LIBOR 4: The Gift that Won't Stop Giving.

The search is on, or let's just make up news.

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 na├»ve 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.

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