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.
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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