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 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.

The Day the Data Died.

Be careful what you say.

After hearing the employment report for September, some of the words of Don McLean’s “American Pie” came to me in a slightly altered form.  This blog has only sparingly discussed employment reports.  The reason is quite simple and is summarized in the e-mail exchange mentioned below.

A former state treasurer forwarded the e-mail with this comment:  “[a friend of his] thinks the 7.8 is proof things are getting better. You may enjoy my reply, and perhaps use the explanation in your blog.”  His reply is shown below:

On Oct 7, 2012 11:15 AM, ….he wrote: 
“The number is Obama's sound and fury... CNN should have told you that... the number is meaningless.
Last night I went to sleep at 190 pounds. This morning I woke up at 189. Proof that my diet is working, or is it all sound and fury so I can have a donut for breakfast?” 

One doesn't even need to address the content of the employment report to realize that his response is correct.  The unemployment rate is much quoted, despite being the most meaningless statistic in the employment report.

That said, the unemployment rate isn't totally meaningless, but it can only be interpreted in the context of the other content of the total report.  Other data from the employer survey, including the change in employment, the change in hours worked, the wage changes reported, and the industry composition of the employment change, are far more important than anything resulting from the household survey. 

Looking just at the household survey, the unemployment figure is much less important than changes in the labor force participation rate, or for that matter, the number of people identifying themselves as employed.  Further, the household survey does not result in just an unemployment rate.  The unemployment rate is estimated in a number of ways.  Other than the so-called “headline number,” the most widely quoted number is the total unemployed and underemployed.  That is shown both as a number and as a rate.  Consistency within the household survey is an important criterion for judging how to interpret a headline unemployment rate.

However, there is one other result than can be derived from the combined employer survey and household survey.  In various postings The Hedged Economist has alluded to the fact that at some point in the recovery, the household survey should start providing employment growth numbers that seem inconsistent with the numbers generated from the employer survey.  The usual response at that point is to question the household survey.  That's exactly what is happening now.

The July 31, 2010 posting entitled “Unemployment map: The geography of a recession” recommended:

“My suggestion is ignore the unemployment rate and focus on the change in employment if you want to measure how an economy is doing. Notice the term was employment; not jobs. It is the failure to realize that employment and jobs aren't synonymous that is the Achilles heel of this recovery.”

This blog’s posting on August 4, 2010 in a posting defending an employment report entitled “An article about a fiction and the employment report,” discussed the issue when it was the employer survey that was being questioned.  At that point, someone was pointing to the employer survey which showed employment gains that were clearly not sustainable given the total employment report and the administrations claims that the recovery was gaining steam. The comment at that time was:

“Problem is he never bothers to show whether ‘companies continued to slash jobs and hold off hiring for months, even years, after profits returned’ is anything new. It’s not. Recoveries don’t come from having the same set of employers hire back people. Recoveries have always come mainly from new or different companies hiring. Interestingly, it tends to be smaller companies and often start-ups from the current or the last cycle….”

The posting went on to note that any talk of economic recovery at that point was extremely premature.  It stated:

“The picture isn’t pretty. The evidence that the needed churn isn’t happening is there. In addition to the behavior of the two different measures of employment, Friday’s report included other data with telling implications: namely, the revisions. The BLS is aware of the limitation of the employer survey (i.e., not adequately representing new and small businesses). It tries to adjust the data to correct for the undercount using what is called the business birth-death model. That adjustment has its primary impact on the last few months of data. The data is then revised when better, some would say real, data become available. Those were the months for which the employment data were revised down. The unavoidable implication is that fewer jobs are being created by new and small business than they expected. This absence of churn among employers deserves more attention.”

The September employment report gives every indication that the policy failures that were the reason the August 2010 report didn't signal the beginning of employment recovery are becoming less important. But, as economists are fond of saying," the recovery is quite fragile."  Put differently, the private sector has healed and is recovering and has reached a point where that recovery could easily become self-sustaining.  What is infinitely apparent is that there are new headwinds, or, I should say, a continuation of the headwinds that undermined the recovery in 2010.  One doesn't have to be a strong partisan to realize that the Obama administration has been anything but friendly to small business.

That said, judging just from the employment report, the recovery is continuing its anemic pace and is poised to accelerate.  That, however, is not a forecast.  This administration has repeatedly undermined the recovery.  To illustrate, if the data could be accepted at face value the employment report itself would quicken the pace of recovery.

It should be pointed out that the suspicion reflected in that last statement is not the normal posture of The Hedged Economist.  My normal posture is reflected in a January 5, 2011 posting entitled “Reality and the jobs numbers.”  It states my normal response to charges of intentional misrepresentation in the employment numbers:

“For those who see political conspiracies everywhere it is interesting to note that the undercount in December coincided with the hearings on extending the 99 week emergency unemployment benefits. I’m amused by the conspiracy theorists. They seem to be part of a massive delusion that government is always in control of its every activity right down to the details. I hate to pop anyone’s bubble, but governments make mistakes. It’s very likely someone just got the number wrong. That they were out of touch with the private economy around them shouldn’t be surprising: they’re government employees after all....This month the news in the employment report released on Friday will be in the sector detail and the household survey.”

That quote should make it quite apparent that in most instances, the best approach is to dismiss such charges as just political rhetoric.  It is, however, interesting how frequently they have arisen during this administration, especially given how inconsistent the employment recovery has been.  That in of itself would not be enough to justify questioning the number.  However, this administration has made it clear by its own statements that it considers generating phony government statistics a legitimate campaign tactic.  That justification comes from none other than Austan Goolsbee, former chairman of the Obama administration's Council of Economic Advisers. Back in 2003, Mr. Goolsbee himself, commenting on a Bush-era unemployment figure, wrote in a New York Times op-ed: "the government has cooked the books."  Clearly, he thinks cooking the books is a campaign tactic.

Even this administration's willingness to admit that it views fudging the numbers as a legitimate campaign tactic is not enough reason to dismiss the good news contained in the employment report.  This is especially true given that inconsistencies between the employer survey and the household survey are a cyclical phenomenon.  The more troubling problem with the employment report is the inconsistency within the household survey.  For the drop in the unemployment rate to represent the positive news on employment growth that will occur at some point during the recovery, it needs to be accompanied by a similar drop in the combined unemployed and underemployed.  It also should have been preceded, as opposed to accompanied by, an increase in the labor force participation rate.

The bottom line, however, is that the employment report can contain data that is just wrong.  It's much easier for one month’s report to contain a number that is wrong than for the report to show a false trend.  Thus, next month’s report will eliminate the ambiguity introduced to the interpretation of this month’s employment report.

It's worth noting in passing that accusations of cooking the books did not originate with Goolsbee's charges in 2003.   They played an important part in Clinton's ability to convince the public that we were not recovering from the recession during his campaign against the first President Bush.  In that instance, after the election the data confirmed that we were in fact recovering.  In this current instance, there is still another employment report before the election.

Thus, the report for October employment needs to confirm this report for September.  A perfectly logical question to ask is what would constitute confirmation.  Clearly, another drop in the unemployment rate without confirming data will only confirm that the administration is cooking the books.  Confirmation should come in the form of a pickup in employment in the employer survey, a reduction in the rate of combined unemployment and underemployment, and revision to this and previous month’s anemic showing in the employer survey.  Of less importance, but also telling, is whether the increases in employment in the employer survey disperses to include more industries.

Bottom line, Jack Welsh’s comments were justified.  The September employment numbers warrant questioning.  Whether they were fudged isn't a political question.  It is question of fact that will be proven over the next few employment reports.  It will be proven, regardless of who wins the election, and woe be to the incumbent if, in fact, they were fudged.  Perhaps the administration will be able to find someone to blame for the error.  Even if they do, the number of people they can fool will decrease.  They'll be undermining their party by their obvious ducking of responsibility for the data their administration generates.

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.

 

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.

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. 

Definition of LIBOR (excerpt from Wikipedia)

“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 ( /ˈlaɪbɔr/) 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.”