Tuesday, July 3, 2012

Ready, Fire, Aim

Are you the firing squad or the target?
So what I told you was true… from a certain point of view.

— Obi-Wan Kenobi, Star Wars Episode VI: Return of the Jedi

The news out of Old Blighty this morning that Bob Diamond, CEO of Barclays, has resigned under pressure seems to indicate the ongoing LIBOR fixing scandal is finally gaining enough momentum to fly off the rails. The current rumblings are that Mervyn King, Governor of the Bank of England, wiggled his stately eyebrows disapprovingly and conveyed, with the minimum regulatory fuss, that, yes, indeed, he would be exceedingly obliged if the presumptuous Mr. Diamond were encouraged to remove himself forthwith to a less embarrassing locale. Like, say, Inner Mongolia. Perhaps unfortunately for Mr. King, Lord Turner of the FSA, and their minions, however, Mr. Diamond is scheduled to testify in front of a Treasury Select Committee tomorrow. Current odds in the interbank lending market are 5 to 3 that Mr. Diamond will celebrate Independence Day by setting off a few hundred fireworks under his former overlords’ derrieres. Honi soit qui mal y pense.

Increasingly lost in the hubbub surrounding this folderol is the nature of the offense. Diamond himself admitted that Barclays did two things wrong. First, certain traders within the bank apparently cajoled, wheedled, and perhaps even bribed the employees charged with submitting Barclay’s LIBOR fixing over a period of several years in order to book profits or reduce losses on their own proprietary positions. While this manipulation may have benefited these individual traders, it is not at all clear that it benefited the bank as a whole. As a huge global commercial and investment bank, Barclays stands on the paying and receiving end of tens if not hundreds of thousands of financial contracts indexed to LIBOR, which is the base rate underlying hundreds of trillions of dollars of loans, mortgages, derivatives, and other financial contracts around the world. On many of these contracts, Barclays pays interest calculated as a spread to LIBOR, and on many others it receives the same. As a whole, one would only be able to determine Barclays’ exposure to LIBOR if one summed up all these obligations to determine its net exposure. It is an empirical question. If one takes the theoretical position that a huge bank like Barclays as a whole should normally be structurally short floating rates—that is, is a net short-term borrower which pays floating rate interest—then one can say an artificial reduction in LIBOR should in fact benefit it by reducing its borrowing costs.1

But that was not the intent of the individual traders and submitters manipulating Barclay’s fixings. They were just trying to pad their own P&Ls and apparently didn’t give a fig for their employer’s overall profitability. This was sheer individual profiteering, and the fact that it occurred repeatedly demonstrates that Barclays was riddled with lousy controls, inadequate supervision, and a culture of individual profiteering run amok. It is not an indictment of banking in general, it is an indictment of what a crappy bank Barclays was.2

On the other hand, Bob Diamond also admitted that, beginning around the time of the financial crisis, Barclays began to systematically underreport its LIBOR fixings to the BBA. It did this, he claims, because executives began to notice its self-reported rates were higher than those of its global peers, which seemed unrealistically low. Because Barclays began to fear that reporting higher LIBOR rates than its peers would undermine the perception of its creditworthiness in the marketplace, it guided its submitters down to the new, improved “market” levels. For what it is worth, Gillian Tett of the Financial Times and others at The Wall Street Journal had begun to report as early as the Fall of 2007 that something was rotten in the state of LIBOR. It seems that every major bank in 2007 and 2008 was submitting bogus LIBOR fixings with the intent to persuade the market all was well (when it most distinctly was not). The kicker is that Barclays now claims its ermine-cloaked stewards at the Bank of England strongly encouraged it to get in line.


* * *

Of course the real question in this kerfuffle is whether this gross, sustained, systematic and perhaps regulator-sanctioned manipulation of base rates used to calculate payments due under hundreds of trillions of dollars of financial contracts worldwide—which I think we can safely say did in fact occur—actually claimed any victims. Certainly not among the banks, who neither could nor would lend or borrow at LIBOR rates from their peers during the financial crisis. Certainly not obviously among the myriad of borrowers who had borrowed at or swapped back into fixed rates, and who happily motored along paying their nice level payments without regard for the shenanigans in the floating rate market. Not obviously among the investment banks, hedge funds, and other active market participants and intermediaries who regularly transacted on both sides of the floating rate ledger either. Perhaps those parties who borrowed on a floating rate basis during the period of artificially low benchmark rates benefited, and the counterparties who loaned to them suffered?

But here’s the rub: virtually nobody borrows at LIBOR. Entities borrow from and lend to each other at LIBOR plus a spread, which is negotiated between the parties at the commencement of the contract. It is the spread which reflects the negotiated price for credit risk undertaken by the lender. Spreads are the true market price of credit. LIBOR is just a number pulled from a page on a Reuters or Telerate terminal.

And consider this: Since no bank believed either their own or any other bank’s LIBOR number back in 2007 or 2008—to the extent that many (most? all?) even refused to lend to each other at those rates—do you think it likely they did not incorporate that knowledge into the market price of credit they offered each other and every other potential counterparty? Do you really think commercial and investment banks did not at least implicitly add 25, 50, or even 100 basis points to their normalized credit spread in each and every deal to compensate for the bullshit discount priced into the reference rate? Do you really think every sophisticated investor and participant in the fixed income and derivatives markets—who could and did compare posted LIBOR rates with the banks’ real market borrowing costs displayed real time in credit default swap and other credit markets—was unaware of this dislocation, and did not price it into their own transactions? Let me suggest an answer to you: of course they did.

In fact, I suspect the only participants who obviously benefited from the systematic manipulation of LIBOR were those who had entered into contracts priced before that manipulation began. In other words, a counterparty who borrowed at LIBOR + 600 bps in 2005 definitely benefited from the fact that they only had to pay 600 basis points in 2007 and 2008, when the correct price may have been closer to 700 bps or more.3 Even banks and other entities which were structurally net short floating rates during this period were unlikely to have benefited fully from the implicit LIBOR discount, because their obligations rolled over on a short-term, almost continuous basis, as is the wont for active financial intermediaries. Each time a bank borrowed money or reset a credit spread during that period, you can be certain its lenders priced the loan at true credit market rates, unconstrained by whatever straw man the banks and their regulators had agreed to put on the Reuters and Telerate pages.

* * *

So, despite the huge numbers involved and its pervasiveness throughout the global financial infrastructure, it is far from clear to me that banks’s systematic manipulation of LIBOR led to vast wealth transfers from one set of market participants to another. No, the real damage this practice caused is what we are witnessing now. The current scandal is the last nail in the coffin of whatever trustworthiness banks may have had left after five years of crapping the bed.

Sure, nobody (or very few people) may actually have been ripped off by this behavior. Sure, systematic lying by banks about their creditworthiness during the financial crisis may have lulled the public into not panicking and triggering a wholesale global financial collapse. (Which most assuredly would have been A Bad Thing.) It may have even helped in more systemic ways.

But I think bankers must now get used to staying in the doghouse for a very long time. It might even be time to pick out curtains.

Related reading:
Donald MacKenzie, What’s in a Number? (London Review of Books, September 25, 2008)
Ryan Chittum, The Libor lie unravels (Columbia Journalism Review, June 28, 2012)
Matt Levine, Libor Can Be Whatever You Want It to Be (Dealbreaker, June 26, 2012)

1 Think of a simple example: Bank A borrows a million dollars in the interbank market on a floating rate basis at 3-month US dollar LIBOR. It then turns around and lends you a million dollar adjustable rate mortgage indexed to 3-month LIBOR plus a spread. Assuming no timing differences in the reset calculation of LIBOR on either “leg” of this transaction, Bank A’s net exposure to LIBOR in this example is exactly zero. LIBOR could be 10% or it could be 2%; it wouldn’t affect Bank A in the slightest. Now sum this up over hundreds of thousands of mortgages, tens of thousands of corporate loans, and tens if not hundreds of thousands of interest rate swaps and other derivative transactions. Good luck figuring that out.
2 And perhaps an indictment of how ineffective or inattentive its regulators were, too?
3 Note, if you retain a shred of charity toward the banks at this point, that many if not most of the people who bought houses with adjustable rate mortgages in the run up to the crisis fall into this category of clear beneficiaries. I can assure you the banks did not intend it to happen this way.

© 2012 The Epicurean Dealmaker. All rights reserved.