Showing posts with label BBA. Show all posts
Showing posts with label BBA. Show all posts

Sunday, June 21, 2009

On The Uselessness Of LIBOR

Most financial experts are aware that the only reason the economy has not yet collapsed entirely, is due to the trillions in governmental safeguards and industrial subsidies. Zero Hedge has written extensively on the topic, and it is nowhere more obvious than here, that virtually the entire financial system is backstopped by explicit and implicit guarantees. And in true pro-cyclical fashion, the expectation for permanent governmental crutches can be best seen in some of the same metrics that in the post-Lehman days markedly went off the charts, most notably the LIBOR rate. From record wides several months ago, LIBOR, which is critical as it is the reference risk rate for trillions in assorted product classes, has collapsed to an unprecedented low. The rate drop has manifested in an inversion of the 1 Yr UST - 1 Yr LIBOR spread, with the latter clearing 100 bps inside of the former: a topic covered in detail previously by reader Gary Jefferey.

James Bianco of Arbor Research has some interesting comments, discussing the immediate future of LIBOR as a true predictor of the interbank lending market, especially in light of the BBA's decision to expand the 16 bank LIBOR reporting syndicate as even it has realized that market participants have lost faith in the impartiality and objectivity of LIBOR. In a nutshell, Bianco notes that LIBOR indications by TARP vs non-TARP bank demonstrates a notable schism in risk perception: it is odd (actually, not that odd) that this has not changed notably since Zero Hedge discussed this topic five months ago.

From Arbor Research's piece:
The Wall Street Journal - Libor No Longer Just London

The British Bankers’ Association said Thursday it has started to allow banks operating outside London to contribute quotes for its unsecured interbank lending rates in a bid to keep its rates as representative of bank borrowing costs as possible…The change in definition will open up the number of banks to include those that are highly active in the London money markets but deal out of their domestic headquarters. This comes at a time when some banks on the contributing panels have merged and some foreign banks have reduced their overseas operations to save costs during the financial crisis and economic downturn. “This is being done so we don’t lose contributors who may in the current financial climate decide they wish to consolidate their operations,” said John Ewan, a director at the BBA. “There are plenty of banks which are very similar to the other Libor banks that can’t currently quote because the may not be physically located in London,” he added.
Comment
In the last few weeks we have had stories proclaiming “LIBOR fails to paint a true picture” and that extraordinary government intervention in this market has distorted the rate so much that banks are reducing their use of LIBOR as a reference rate for new unsecured lending. It still remains the reference rates for trillions of existing loans, securities, derivatives and bank deposits. Currently there is no good alternative to LIBOR, although the Overnight Index Swap (OIS) is trying to replace it with limited success. So, the marketplace is searching for an alternative with many banks attempting to devise their own measures to varying degrees of success.

If LIBOR does lose its standing as the reference rate for short-term lending, it would not be the first time such a thing happened. 25-to-30 years ago the reference rate was the Prime Rate, the rate banks charged their best customers. This rate was heavily influenced by a bank’s funding costs as measured by it’s certificate of deposit (or CD) rate. In the early 1980s CD rates became wild and unpredictable, so the banking community began looking for another reference rate. It took years to settle this dilemma, but LIBOR eventually became the preferred measure.

The switch to LIBOR was sealed when Continental Bank of IL failed in 1984 causing their CD rates to soar relative to all other large banks. Continental CDs were used to calculate average CD rates for futures contracts and other measures used to set short-term lending rates, meaning everyone wound up paying higher short-term rates because of Continental’s problems. This cemented LIBOR’s standing as the reference rate for anything related to short-term rates.

Given all this we see the BBA’s move to change LIBOR as a natural response to protect their franchise. World central banks have used the Term Auction Facility (or TAF) in a heavy-handed way to suppress LIBOR. They are doing this because virtually all subprime adjustable rate mortgages (ARMs) are reset using LIBOR. In other words, world central banks are subsidizing shaky mortgages by artificially lowering the reference rate used to reset rates every year. The problem is banks are not happy with the effect this has on other lending and are looking for alternatives.

The tables below help detail how LIBOR is currently calculated. It shows 3-month USD LIBOR.

16 banks report their rate to the British Bankers Association. The four highest and lowest rates are dropped, and the average of the eight remaining rates is disseminated as LIBOR. The process is repeated for a range of maturities ranging from overnight to 12-month loans and across a set of ten major currencies.
The charts below differ only in the date range. They show the difference in the average LIBOR rate for the three banks that have accepted TARP money (BofA, Citi and J.P. Morgan) versus the two Japanese banks (Bank of Tokyo and Norinchukin). We believe the Japanese banks are the farthest from TARP banks on the spectrum of government intervention.
As the crisis heated up and U.S. banks accepted TARP money, the difference between their LIBOR posted rates and the Japanese banks increased. In all cases TARP banks have been offering LIBOR loans below the average of Japanese banks. Note that prior to the crisis (2004 to 2007) there was practically no difference between these groups.

This does not prove LIBOR has been politicized. But if it was, this is exactly what one would expect to see in these rates.



Curiously, the LIBOR debate is moving to a more econometrically-focused audience and has led none other than the San Francisco Federal Reserve to come out and indicate that LIBOR is essentially flawed as a metric, as it now reflects not so much the risk in the system, but the guarantees by the US government itself. In a working paper "Do Central Bank Liquidity Facilities Affect Interbank Lending Rates?" the SF Fed concludes that not only is LIBOR useless in the current complete "socialization of risk" environment, and also attempts to quantify the impact (and thus get a FV reading) on this pro-interventionist-cyclical metric. Recommended reading.

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Monday, January 26, 2009

Fannie, Freddie, FHLB About To Remind World Of Their Pathetic Existence

As Bloomberg reported last week, Tuesday, January 27, may be much more than consumer confidence / Case-(C)hiller day. On Tuesday the Federal Housing Finance Agency, the government oversight agency run by Jim Lockheart, will announce a new set of parameters for capital requirements and investment restrictions for Freddie, Fannie, and the Federal Home Loan Banks. Freddie and Fannie, which were nationalized in September, hold a combined $1.7 trillion in mortgages between them. Lately they have been somewhat behind the scenes, absent the occasional cry for extra capital. What should be much more concerning is the status of the FHLB system, which is the single largest U.S. borrower after the government itself, with $1.25 trillion in debt. The member banks provide low-cost loans to more than 8,000 member banks and finance companies, including banking behemoths Bank of America, Citigroup and JP Morgan. What is worrying is that according to Moody's stringent standards for capital sufficiency, as many as 8 of the 12 banks may fall short of minimum capital requirements as auditors require writedowns from their $76 billion of private mortgage bond holdings to market.

The big unknown is whether tomorrow Lockhart will tighten or loosen the banks' capital requirements, aka reserves against losses. According to Bert Ely, a banking consultant, “[the FHFA] will bend over backward to not cripple the Federal Home Loan Banks or the member institutions. They are a major source of funding for the banks and thrifts" that are making home loans.

On the other hand, Rajiv Setia, a Barclays analyst said he wouldn't be surprised if FHFA increased the capital requirement, "From a regulator’s perspective, what’s my upside in lowering the requirement and then, say you’re wrong. If I’m a regulator, I want to be more punitive because I’m protecting my domain."

The banks are required to hold a minimum capital cushion equal to 4% of assets to reserve against losses, and according to Lockhart the proposed change to the rules will lay out when a bank can be classified as "adequately capitalized, significantly undercapitalized or critically undercapitalized." As the FHLB is lobbying the FHFA and SEC hard to be allowed to stop margin mortages to market, one can assume what the proper classification should be.

In the past two weeks, the Seattle and Pittsburgh FLHBanks said they are either likely to fall shortly of capital requirements for Q4, or to be narrowly in compliance. Both banks, plus the San Francisco FHLB, have suspended dividend payments to protect reserves.

Could the market be ahead of the government in this one? FT Alpha points out the aggressive rise in 3 month LIBOR over the past week, which has gone from 1.12% to 1.18% in 5 days, is indicative of the potential risk from a change in the regulatory framework. As we have pointed out previously, 3 of the 16 banks that make up the BBA committee that sets the LIBOR rate, Citi, JPM and BofA, are not only direct beneficiaries of the FHLB's generosity (and continued existence), but are also the BBA members that recently have posted some of the lowest LIBOR rates! The following blurb from Bank of America analyst Michael Cloherty describes the incestuous relationship between capital preservation tactics at the FHLB and the ultimate impact on LIBOR:

"In order to borrow from the Home Loan system, banks must buy FHLB capital notes which pay a dividend. The FHLB system then levers up this capital roughly 20 to 1 by issuing debt, and lends the proceeds back to the borrowing bank. So the all-in cost to the borrowing bank is the rate on the loan minus the dividend income received on the capital note.

Historically, in order to preserve capital the regional Home Loan Banks first stop paying dividends on their capital notes (other options include not allowing banks to redeem capital notes that are not being fully borrowed against, calling in more capital from member banks, or receiving a capital injection from the Treasury). This dividend reduction is already underway- in Q3 2007, the average dividend was 5.16%, while in Q3 2008 it was 3.50%.

But if we assume one of the FHL Banks pushed its dividend to 0% to preserve capital (a 350bp reduction), that would raise the cost of funds for a bank borrowing to full capacity (assume 20 to 1) by roughly 15bps. This would likely cause banks to be more aggressive in financing themselves through wholesale deposits, which would impact the LIBOR setting."

Is the LIBOR trend indicating an expectation that the FHLB may soon be in deep trouble and/or follow the fate of its Freddie and Fannie zombie cousins? If the 3 major depositor banks, which previously could rely on the FHLB for cheap financing, are forced to rely exclusively on pricier depositor assets, this could be yet another fat tail that whacks the house of cards known as the U.S./global financial system. Sphere: Related Content