Brent Nyitray
Fairlington Blade
Let the mutherfuker burn!
jnc4p
Kevin S. Willis
Michigoose
lmsinca
markinaustin
Arcanaut
novahockey
quarterback
ScottC
yellojktSo I figured it was time to weigh in with a post about the LIBOR scandal. I will say upfront that, while it is a scandal, I think that, because of the general bank-bashing atmosphere that prevails in certain media and political circles right now, it has been blown far out of all proportion. Our own jnc has tended to focus, not unreasonably, on the implications that the scandal presents for the kind of culture that prevails in the finance industry. While I don’t agree that it is nearly as indicative of a widespread culture of dishonesty and corruption as jnc seems to, I think it is at least a fair question. I have no time, however, for the Taibbis and Simpsons of the world who are doing their utmost to portray this as some kind of huge and concerted rip-off of Main Street, municipalities, widows and orphans, or whoever else is their latest chosen victim. That is just a bunch of bunk.
There are actually two separate issues here, and they need to be discussed separately. The first is the claim that individual traders were routinely manipulating the daily LIBOR set, both higher and lower, to benefit their trading positions on any given day. The second is that, during the crisis of ’08, some banks were reporting falsely low borrowing costs in order to keep their funding difficulties from becoming public information. Let’s address the former first, and perhaps a little history would be useful.
Prior to the advent of LIBOR swap contracts used many different floating rate indices such as Prime or T-Bills (which is of course manipulated by the Fed as a matter of course), and even at times an individual bank’s own lending rate, determined solely at it’s own discretion. Then in the mid ’80’s the demon derivatives market invented LIBOR in order to standardize swap contracts by basing them all off of a single, reasonable and standard measure of a “premium” bank’s borrowing cost. Banks liked this because, even if the published rate was not exactly their own borrowing cost, it was a fair enough approximation to make their contracts sensible. Spreads could be added to this standard for individual contracts to account for the varying credit quality of the contracting parties, but LIBOR would represent a baseline index. In the beginning there were actually competing publishers of daily LIBOR rates, each with their own methodology of calculating the rates. There were different contributors as well as different averaging and rounding conventions, and so the “standard” wasn’t quite that. But over time the British Bankers Association’s published BBA Libor became the dominant rate and eventually the market standard.
From the first, LIBOR was defined broadly and was never meant to be some exact rate that mirrored an already established market rate. In the first place, it’s nature as an average of many different bank rates, with both high and low submissions being deliberately excluded, makes it nothing more than an approximation anyway. Second, the rate that the BBA requested as submissions was always very subjective. Originally the BBA simply asked each contributing bank’s opinion of where an unnamed, generic “prime” bank might be able to borrow: ““At what rate do you think interbank term deposits will be offered by one prime bank to another prime bank for a reasonable market size today at 11am?”.
Later, in 1998, it changed it’s question to “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?” So now, rather than asking about a hypothetical bank’s borrowing costs, it was asking about the bank’s own borrowing costs. But note the qualifying and indeterminate language. What is “reasonable”? What if you weren’t actually in the market “just prior” to 11 am? What if you borrowed from three different banks at three slightly different rates? What if you borrowed at 10am, and then saw that the market sold off between then and 11 am? Do you submit your actual rate or what you guess it would have been an hour later? What if you weren’t a borrower at all, but were in fact lending to other banks on a given day?
The main point here is that, contrary to the perception being fostered by outraged pundits and opportunistic politicians, there is no single, objectively knowable “correct” rate to be submitted by any given bank. Obviously there is not only room for a subjective interpretation and judgment on the part of the individual submitters, such a judgement is often actually required. There is some range of rates within which it is perfectly reasonable to have submitted, even of it is not an actual rate that you transacted.
Now, if one is tasked with submitting the daily rate to the BBA, how does one make this judgement, and is it ethical to be influenced by the entreaties of traders who stand to benefit or lose from your judgement? That is a fair question and perhaps a point worth debating. But I actually think it is debatable. If the nonexistent “correct” rate falls within a range of, say, 3 or 4 basis points, is it really wrong or unethical to take into consideration the financial well being of the company you work for when deciding whether to report the high or low end of the range? I don’t think so, at least not necessarily. And the fact that one rate within the band is chosen and not another does not mean that the rate has been criminally “manipulated” or that the rate has been “fraudulently” submitted. As long as the submitted rate is defensible on the merits, regardless of how the judgement was arrived at, I don’t see a problem. Certainly, in any event, this is not some “criminal conspiracy” akin to the mob shaking people down.
And in fact the whole process of calculating LIBOR takes all of this into account. That is precisely one of the reasons that such a wide number of banks (18) are polled and averaged, and why the high and low submissions are excluded from the average. As the BBA itself says, “The decision to trim the bottom and top quartiles in the calculation was taken to exclude outliers from the final calculation. By doing this, it is out of the control of any individual panel contributor to influence the calculation and affect the bbalibor quote.” Which brings us to another, and I think more important question: Regardless of whether routine attempts to influence the submissions are ethical, were they successful in changing the rate?
That will be the subject of a future post.
Filed under: Big Banks |
All Things in Moderation 
Thanks Scott. I’m still digesting it but off the top of my head I’d say I understand LIBOR a little more at least. In some ways though I think the banks have brought the “general bank-bashing atmosphere” on themselves by a string of questionable if not outright criminal practices. It would matter I think if many banks got together to set the interest rate as low as possible and just who that affects positively or negatively is important in my opinion. You’re probably right though, it’s not as big of a scandal as being portrayed. I do think it’s interesting however.
I’ll look forward to Part 2.
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Scott, would it take 5 banks colluding to skew the rate? I think I would be interested in the evidence of collusion, before I thought I had even a rudimentary grasp of the nature of the beast.
Why did Geithner think manipulation was a problem when he was at the NY Fed?
I have not been keeping up during the move. Your post is the most information I have received about any single news topic in a week. I am going to fwd your two posts to my old friend who is chief international economist and VP at the Dallas Fed, for his POV. His narrow field is Latin American banking and finance and its interaction with the southwestern tier FRBs, but he will tell me if this is outside his realm.
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Mark:
Scott, would it take 5 banks colluding to skew the rate?
In theory, a single bank could skew the rate to some degree, as long as he didn’t try to skew it so much that his submission was excluded from the average. So, since 12 submissions are included in the average, a single bank’s ability to move the rate would be 1/12th of the difference between the highest of the 4 excluded low submissions and the lowest of the 4 excluded high submissions. The tighter the range of all submissions by all banks, the lower the ability for one bank to move the rate.
5 bank’s colluding together would guarantee an ability to move the rate, since not all 5 of them could be excluded from the average, and together they could dictate that spread between highest of the lows and the lowest of the highs.
However, I believe the BBA retains, and has exercised, the right to alter the panel of submitting banks from time to time, so if it noticed that a bank or banks were routinely submitting unrealistic rates relative to others, it could remove them from the panel altogether and add different banks.
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Outstanding Scott, thanks.
Somewhat OT, but here’s a hilarious Twitter exchange between the HuffPo Congressional correspondent and a dude from NewsBusters:
http://twitchy.com/2012/07/14/newsbusters-editor-takes-huffpo-bureau-chief-to-economics-school/
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One irony being that consumer borrowing rates are set on top of such a squishy standard. Perhaps someone could set up a group at NIST to help out. 😉
BB
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FB:
One irony being that consumer borrowing rates are set on top of such a squishy standard.
Not really. Consumer borrowing rates have always been set by lenders at whatever rates the lender wants to lend at. The fact that banks now routinely set their lending rates relative to some third-party determined rate, squishy or not, reflects both a) bank confidence in the rate as an objective measure of its own borrowing costs and b) a step forward in transparency between lenders and borrowers.
BTW, consumers always have the option of not borrowing, if they don’t like the rate. For example, mortgage rates are often determined relative to LIBOR, but ultimately it is a fixed rate that is agreed to. It doesn’t matter much how it was arrived at. If the borrower doesn’t like the rate, he doesn’t have to borrow.
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Given that Timmy Geithner and the British government knew about this in 2008 at the latest, you can expect all the crimiinal probes to quietly go away while the massive civil suits flourish.
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Edit: some consumer rates.
I rather wish plenty of people had taken the option of not borrowing. As a fiscally conservative sort of fellow, we obtained a fixed rate, 15 year mortgage in 2005. When rates are at decades lows, what kind of idiot picks up an ARM? Evidently, there were a lot of idiots on both sides of the desk.
With rates being at even greater lows now, I’m considering moving up. Even though we’d take a hit on our place, a 3% 15 year mortgage is really attractive. There’s some larger townhouses in attractive neighborhoods close to us. My guess is we’d put down about 25% and our payment would only increase by $400. Tempting.
BB
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To BB: Would you take a hit in that you are underwater, or in that you would have no capital gain to show for the experience?
To Scott: Thanks.
To Kelley: I am guessing that male responses are still typically to the individual. Some women who are aesthetically gorgeous are not attractive to me and some who are quite ordinary looking are. And I cannot predict this at all, before the fact. Maybe the other guys here have had the experience of being attracted to a specific visual type, again and again. I do not mean in the abstract, as with celebrity hotties, but in the real world with acquaintances.
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Mark – We’re not underwater as I was quite cautious. I’m not blowing smoke in that I’m fiscally conservative. We put down a bit over 10% and are just past 7 years on a 15 year mortgage. I was also wise, errrm, lucky. We bought in close (about 5 miles SW of the Pentagon and close to the new DoD facility at the Mark Center). Prices took a hit here (~10%), but are rebounding. Arlington did better than Alexandria, likely due to the reputation of its schools as well as the surge of the Metro corridor. We owe only a little over half what we could sell the place for. My estimate is that we could put down about 25% on the kind of place I’d like to buy. We’ve more in the bank that is set aside to pay off Keen’s student loans soon.
We love the place we have here [to the peanut gallery, Mark has visited in person] and would like to enjoy the hard work we put into it a bit longer. Yet… the prospect of a 3% mortgage is tempting. My rough estimate is our mortgage payment would go up by about $400/month. Taxes would probably go up by $2000/year. It’d be manageable, especially once we clear the student loans.
BB
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“a 3% 15 year mortgage is really attractive. ”
I’m about to refi into one of those. consolidate some debt. the monthly will go up a bit, but i’d rather pay more in principal than interest. and have the house paid off about the same time my son would start college.
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Thanks for explaining this. It was very informative. I hadn’t realized the process was quite so informal.
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NoVa – There’s a very tempting place on Dogwood Lane, down the block from the 7-11 on the corner of Dogwood & N. Quaker. That’s the one for which I calculated we’d pay an extra $600/month, though we wouldn’t be paying a condo fee anymore.
BB
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God love the interents — i think i found the house you’re talking about. That’s a great area. I used to walk the dog past those homes when were in in parkfairfax. plus its close to one of my favorite little wine shops. http://www.fernstreetgourmet.com/
easy commute, walkable to shirlington (a bit long, but doable).
I can appreciate the willingness to get rid of the condo fee. seems like the one i pay in on my rental is simply for maintenance.
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I spent a year on the board of my condominium association, so I appreciate where the money goes. Big costs like repainting or roof replacement get evened out. I’d probably wind up paying a fair amount for home owner’s insurance, which is covered by the master insurance policy right now.
Fern Street’s a great shop. I’m a regular at the nearby Unwined, but occasionally drop by Fern after stopping by Ramparts next door. Fern Street’s a bit better on cheese than Unwined. I think Unwined is a bit stronger on new world wines, especially South Africa.
BB
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