Saturday, July 7, 2012

Who put the lie in Libor?

Who put the lie in Libor?
By Chan Akya

On July 4, with nothing much to do as markets were closed, I switched on the television; and was presented with the wonderful choice between watching the cult HBO series Game of Thrones on my recorder or the live testimony of Barclays' former chief executive Robert "Bob" Diamond in front of a UK Parliamentary Committee. I almost inevitably chose the channel with the brilliant acting, brutal violence, fantasy characters, unbelievable plot line and massive special effects. Game of Thrones could barely compete with all that drama on live television.

Last week, I wrote an article that bemoaned the collective escalation in comfort levels that pushed us into accepted sub-optimality as a way of life (see
Naked emperors, holy cows and Libor, Asia Times Online, June 30, 2012). That may have done a disservice to what has since shaped up into one of the big scandals of this year.

That said, I hardly believe that the current media coverage of the Libor "incident" is any way representative of the key dynamics actually at play. Specifically, the media appear to be quietly sweeping a few inconvenient issues under the carpet: 1. Did Barclays manipulate the London Interbank Offered Rate, or Libor?
2. How did Libor become a benchmark?
3. Where is the body, dude?
4. Was Bob Diamond unfairly targeted?
5. What is the best way to fix Libor in future?

Did Barclays manipulate Libor?
The British Bankers' Association defines Libor as the following:
The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size, just prior to 11.00am London time.
The Oxford English Dictionary defines the word manipulation as the following: Noun [mass noun]
1. the action of manipulating something in a skilful manner: the format allows fast picture manipulation
[count noun]: conscious manipulations of oral language
2. the action of manipulating someone in a clever or unscrupulous way: "there was no deliberate manipulation of visitors' emotions".

Read again the bankers' association definition - the key words are "could", "were", "by asking", "accepting" and "reasonable". At the best of times the definitions are woolly, and at the worst meaningless. Simply put, a "price" is what someone actually transacts at - not a sticky label on a shiny object in the middle of a store. That label is called "marketing" - not a "price".

Put another way, ask a farmer what he thinks his crops are worth: the ones that he lovingly took from seedlings and grew to a wavy golden field of grain and he'd probably quote a few bushels of gold. Ask him what he actually sold it for, and it would be a few coins. The difference between the two is the one between "value" and "price".

Therefore, Libor could never be either representative or completely truthful. The reason it worked as truthful submissions was that when banking risks were perceived as low, the borrowing rates of various banks were fairly close to each other, that is, there was very little dispersion in the price between various banks. That factoid ironically enough forced banks to be exactly right every day because they didn't want to be embarrassed by being seen outside the crowd.

Now, for a second there, pretend that the past five years never happened and cast your mind back to this time in 2007. As US mortgage defaults escalated well beyond what had been expected and a host of SIV (structured investment vehicles) that had supported money markets simply imploded, European banks were scrambling for liquidity amongst their own kind, that is, the "inter-bank" market.

Then, the UK's Northern Rock bank went belly up (see
Rocking the Land of Poppins, Asia Times Online, September 22, 2007), barely a week after starting to lie about its liquidity and borrowing prowess in the Libor market. That's right - the first bank that went belly up in the financial crisis actually lied in its Libor submission by, among other things, pretending to be a lender in the market when it was actually a desperate borrower.

You would think that a regulator who had just seen that would have become wiser; but then again you are not a central banker so you are thinking wrong about this. The UK's central bank - the Bank of England - and its supervisor, the Financial Supervisory Authority (FSA), both missed the story.

Or did they? Diamond's testimony clearly highlighted an initiative on the part of the British authorities to talk down the Libor submissions to present a rosier picture of the banking system. Why would they do that? Well for one thing, banking assets were (and remain) significantly larger than even the size of the UK economy. Plus, the authorities already had egg on their face from the Northern Rock blow up - thus the impetus to present a Potemkin village in UK banking cannot be excluded.

Therefore they had every motive (not to mention unquestioned ability) to get banks to show themselves to be in better health than they actually were. That effort to push down rates would have logically enough started at the strongest UK banks, namely HSBC and Barclays.

In any event, what happened in the markets at the time was that dispersion between banks increased dramatically as banks stopped trusting each other. When that happened, the theoretical borrowing rate became laughably divergent from the actual rate at which the bank may have borrowed, if it could only find a willing lender. So it was that when Barclays posted higher interest rates than other banks that were already onto fictitiously low interest rates, they got a quiet call from their regulators asking them to "shape up".

No more of this honesty nonsense old chap; we have a country to run you know.

That's the truth. Did Barclays fiddle around with Libor? Yes. But did that fiddling change the nature of Libor? Probably not any more than what other banks did at the time.

How did Libor become a benchmark (or how to bring Kim Kardashian into an article about financial economics). Barely 20 years ago, the "benchmark" for global interest rates was the US Treasury bond. All the world's bonds were quoted as a spread over comparable maturity US Treasuries.

Twenty years prior to that, ie in the 1970s and succeeding Bretton Woods (casting off the gold standard for good), the introduction of the "eurobond" market (to dodge interest withholding taxes in the US market) and the oil embargo (which caused a massive inflation spike), a number of bonds had been issued on a floating rate - instead of issuing a 10-year bond at today's interest rate and then paying the same rate for the next 10 years, companies and banks started issuing bonds on rates based on floating indices - the theory being that when rates fell (as economies slowed down) they could better afford lower coupon payments and vice versa.

Even so, outside the eurobond market, the benchmark remained the US Treasury bond - whether you were trading US mortgage-backed securities or Argentine government bonds. This in turn led to the measure called the "TED" spread - the Treasury-eurodollar spread - a broad measure of systemic risk at a time when systemic risk wasn't all that pronounced.

Then came the Bill Clinton years, which saw both the diminution of the Soviet Union as a power (a factoid that most current accounts assign to the decade prior, conveniently under Republican leadership) and the boom in the US economy ahead of the dotcom bubble and the government's success at balancing its budget.

The combination of these events led many in the markets to believe that the overall stock of US Treasury bonds would diminish constantly; therefore it became plausible that a few years hence there could be insufficient Treasury bonds to be used as a risk hedge for interest rate movements.

Particularly, the growth of the US mortgage market became hectic and quite soon the size of US mortgage-backed securities outstripped the stock of US Treasuries. The golden rule is that you can't have a hedge that is smaller than whatever the heck it is supposed to be hedging: a bit like a string bikini fighting to restrain the ample curves of US celebrity Kardashian; so the need of the hour was a benchmark that was potentially infinite because banks could manufacture transactions based on Libor at will.

Ergo, Libor.

Where is the body, Dude?
No, not the body of Kardashian; that's for the previous section only. What I mean of course is that at the scene of any crime, one needs a victim. So who exactly were the victims of the Libor scandal?

Perhaps the funniest bits in the media today - and way too numerous to name and shame here - pertain to the widely spread notion that mortgage owners in the US and elsewhere ended up paying more for their mortgages because of the Libor scandal. Nothing could be farther from the truth - the opposite is the case, as the Libor "incident" was about pushing down interest rates artificially rather than pushing them up.

Did pushing down rates benefit the banks - well yes, because it pushed down the value of certain hedges they had built that were tied to bonds that carried low interest rates. That isn't the same though as suggesting that consumers ended up paying more for their loans because of what banks did in the Libor "incident".

If anything, it was savers who were hurt most by the banks colluding to artificially push down Libor. That's because if banks had been truthful about what they were paying each other, they may have been tempted to pay depositors more for their money as well. Central banks too wouldn't have rushed to cut rates in that scenario (because the efficacy of monetary policy would be absent) and instead focused on direct capital support for banks - something they are belatedly on to today in Europe.

Then again, there is a small cabal of folk - numbering less than a handful - who have over the past five years stolen literally hundreds of billions of dollars from savers globally. What would the media do with this handful of criminals when presented with the incontrovertible evidence of the crimes of such people: get out the pitchforks or quietly slink away into the corner, muttering to themselves? Think that through - ask yourself what an extra 5% means for the global stock of savings, and who pushed it down?

Step forward, Federal Reserve chairman Ben Bernanke, Bank of England governor Mervyn King and European Central Bank president (and previously Bank of Italy governor) Mario Draghi. There, you have your culprits. Now tell me what you are going to do with them.

Was Bob Diamond unfairly targeted?
In no particular sequence, I am going to describe a few facts that oddly stack up in a variety of different ways: a. Bob Diamond (born Concord, Massachusetts) is a fervent supporter of US Republican presidential candidate Mitt Romney and was scheduled to host a fund raiser for him this week;
b. The US administration's poster boy for banking, JPMorgan Chase chief executive Jamie Dimon, looks rather tarnished these days, what with his bank's US$2 billion boo-boo in trading losses revealed last month now looking more and more like a $10 billion blow up;
c. As a matter of prudential business, Barclays stepped forward to settle on a long-running investigation when it knew that further disclosure of facts would simply irritate the very regulators who were supervising it;
d. Said regulators were fairly miffed with Barclays for attempting a series of "adventurous" banking actions, including an ill-fated balance sheet swap trade known as "Protium" that saw billions in risky bonds going out of and back into their balance sheet (insert here another wildly inappropriate suggestion about Kardashian and her bikini).

Put those four factoids together and roll them around a little kettle, and what you get looks awfully a lot like "not an accident".

Okay Einstein, how would YOU fix Libor? I have already made the point earlier in the article, but the basic idea is to capture actual trade data and present a smoothing formula that allows markets to discern key benchmark interest rates. Put another way, when you capture the broad swathe of trades between banks in the money markets it is possible to get the correct average.

However, you would need to adjust for a bunch of factors, including:
a. Size of the bank;
b. Size of the borrowing;
c. Term (maturity) of the borrowing;
d. Currency.

You cannot always find, for example, the rate at which banks will be lending each other Malaysian ringgit for the 12-month maturity timeframe. That's fine - the important thing is to establish the basic relationships between markets; for example the US dollar, yen, euro, pound sterling, yuan, Indian rupee, Brazilian real and so forth. Then you create a matrix of actual transactions between banks of a given size (say the world's top 250 banks or even its largest 500 banks) to create an information set.

From this information set, pick up the most representative samples based on bank quality, size and maturity. That benchmark would be real - because it is based on an actual transaction.

Snide references to Kim Kardashian aside, the article summarizes the key issues raised by the Libor "incident", in no particular order making the points that Barclays cannot be accused of manipulating something that has no proper definition, that it is actually possible that Diamond was targeted very long ago, that the process of choosing and calculating benchmarks can become a whole lot more logical, and lastly that the true culprits in this whole sorry saga remain the central bankers....

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