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.
Conclusion 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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