When the Barclay’s scandal about reporting lower-than-actual
costs of borrowing to those who compile the Libor rate (London Interbank Offered Rate) I thought,
“Isn’t this old news?” Sure enough, Calculated Risk, a blog I follow, posted a bunch of links that reminded me why I had indeed
come to believe Libor was something of a fiction.
For the record, let’s back up a bit and describe what Libor
is—and it’s not one thing; it’s actually 150 things: Libor rates are set for
fifteen maturities and ten currencies. Every day around 11:00 a.m. major London
banks report the rates they “expect” to pay to borrow for various lengths of
time. The compiler ignores the top and bottom 25% of reported rates and
averages the middle 50% to determine the Libor rates, which are released to the
public at 11:30. Banks, insurance companies, credit card companies (and maybe
even loan sharks for all I know) use these rates to determine the interest
rates they charge on loan balances. If you check your loan agreement you may
find that it calls for something like the 3-month Libor rate plus 2.75%.
The first thing to note is that if only one bank was
misstating their rates by substantially over- or under-reporting their
borrowing costs, it would make little or no difference to the Libor rate since
the high and low outliers are excluded from the calculation. To make a
difference to the reported rate requires malfeasance on the part of a
significant portion of the reporting banks.
From documents reported so far, it appears that especially
in the midst of the 2008 financial crisis many banks understated their reported
Libor rates. People began to use the Libor rate as a proxy for understanding
each bank’s health, which explains why a bank might report a lower rate than their
real borrowing cost. No CEO wants others to view their bank as vulnerable. If
no one will lend to a given financial institution, it will soon have to shut
down. (See Lehman Brothers for example.)
As a consumer, this chicanery might actually be good news. If
your loan agreement ties your interest rate to an understated Libor rate, you
aren’t charged as much as you should be. You win; your lender loses. That is a
zero-sum game. Holy financial boondoggle, Batman, the banks screwed themselves?
Well, for sure they screwed those brethren not able to offset the losses from
preternaturally lowered Libor rates. However, some banks have trading arms that
take financial positions on (among other things) the movement of Libor rates.
If you knew the rates weren’t going to move as much as the economics of the
time suggested, perhaps you’d be a wee bit tempted to place a bet given your
inside knowledge.
Perish the thought anyone in the financial industry might
use inside information. The fools who took the other side of the Libor bets
thought they knew better—but what does that say about them when someone like
me, a simple retiree with a bit of time on his hands, was convinced the banks
were not reporting accurate figures.
As individuals we need to keep in mind that we should never
invest in something we don’t understand. That includes not investing money with
someone who buys and sells financial instruments you don’t understand—it’s just
as likely they don’t understand those financial instruments either. As further
proof, just look at the hedging operation that has already cost JP Morgan Chase
billions and they haven’t completely unwound their position.
As usual, the lawyers will make out the best since they
represent both sides of all suits (and they have already started over the Libor
mess) and always figure a way to be paid.
Oh, and if you want a way to fix the problem of the phantom
reporting, here’s my solution. Forget about publishing an expected rate. Have
the banker boys tell us the highest rate they actually paid during the last
12-hours. There might be a bit of a lag in the data, but we can audit the
results and put behind bars those who lie. Which would you prefer, fresh lies
no more than 30-minutes old or half-day-old truths? I’ll take the truth, thank
you.
~ Jim
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