As we discussed in part one of our Q1-2 2023 Economic Outlook, the financial sector appears well-positioned for an economic downturn. That being said, we are seeing the deterioration in delinquencies ...
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5 min read
"Each year, the Great Pumpkin rises out of the pumpkin patch that he thinks is the most sincere. He's gotta pick this one. He's got to. I don't see how a pumpkin patch can be more sincere than this one. You can look around and there's not a sign of hypocrisy. Nothing but sincerity as far as the eye can see." – Linus Van Pelt, It’s the Great Pumpkin Charlie Brown!
Way back in the summer of 2017, nearly four years to the day of this writing, Andrew Bailey, Chief Executive of the U.K. Financial Conduct Authority delivered a speech that shocked the financial world. Mr. Bailey, who is now Governor of the Bank of England, told us that the most important financial benchmark, Libor, was a made-up rate. Mr. Bailey informed the planet that the transactions that were supposed to feed the panel bank submissions did not exist, and not just in 2017, but were pretty much non-existent since the 2008 Financial Crisis.
Every day, the 18-panel banks were to submit a rate for U.S. Dollar, Libor, that reflected where they could borrow from another bank for reasonable market size on an unsecured basis from overnight to 12 months. This was not supposed to be a forum where the panel banks gave their daily guess on where they could borrow unsecured from another bank. It was supposed to be based on real transactions. What the world learned in the summer of 2017 was, for approximately nine years, the panel banks were simply giving their “expert opinion” because they were no longer lending unsecured to one another. Moreover, they never bothered to tell anyone.
The question that very few have asked is just what exactly the panel banks were doing to formulate their daily “expert judgments”. Since they have never really been asked what they were doing the last nine years, they have remained silent. In 2014, reacting to the scandal that involved swap traders buying lunch for the funding desk in order to entice them to increase or decrease their daily Libor submission back before the 2008 Financial Crisis, a new administrator was named, the Intercontinental Exchange or ICE. With a new sheriff in town, the submission process was improved, except for the little issue of panel banks issuing submissions every day that were based on fiction.
Also in 2014, with extremely little fanfare, a committee consisting of the 18-panel banks and members of the Federal Reserve and Treasury Department named the Alternative Reference Rates Committee (ARRC), was formed. This group met once a month starting in the spring of 2014 to come up with a Libor replacement. What is interesting is that this group was meeting to try to come up with a new rate because the banks and the Federal Reserve knew the glaring weakness of nearly zero market-based transactions in unsecured inter-bank lending! It was even more interesting that the only market participants on the committee until late 2017 were the panel banks, which included the same guys who were being fined and sued for messing around with Libor before and during the Financial Crisis.
While the ARRC was meeting and essentially getting absolutely nothing accomplished, the rest of the world went right on believing that Libor was a real rate and continued to print trillions in transactions that were tied to Libor until Mr. Bailey broke the news. Once the news broke, the ARRC busied themselves by actually bringing in other participants, such as non-panel banks and large money managers, and trying to come up with a Libor replacement. Before we get to the plethora of potential replacements, a logical question needs to be asked. If the panel banks spent more than nine years coming up with rates every day without market-based inter-bank unsecured lending transactions, then what were they using to come up with the rate submissions?
Since hardly anyone has put forth the argument that perhaps the panel banks skewed Libor one way or the other, then why all the brain damage of trying since 2017 to come up with a suitable replacement? Why can’t we just use the wisdom the panel banks imparted to the marketplace every day from 2008 to the present with their Libor submissions? We will leave that an open question, except to say that the panel banks' wholesale funding relies heavily on Libor, and the lower Libor the better.
Currently, there are three main contenders for the Libor replacement crown. We have the Secured Overnight Financing Rate, or SOFR. This is the favored rate by the Fed and the panel banks. The problem with SOFR is it is a Treasury bond funding rate that is subject to swings having nothing to do with credit or term premia. The ARRC is trying to solve this problem by creating a futures market (which allows for the creation of term SOFR as opposed to just overnight), as well as coming up with a credit spread for the rate. The only problem is that, besides the panel banks and the Fed, everyone hates SOFR. The force-feeding of SOFR is akin to a Little League coach insisting that their kid pitch and bat third every game even though they can’t hit or pitch very well. Then, there is the proposed replacement from ICE called the Bank Yield Index and Bloomberg’s Bloomberg Short-term Bank Yield Index. Both of these indices rely on where the bank is unsecured senior debt trade with terms similar to the current Libor tenors. We think these indices are promising. However, as of now, they have not gotten any buy-in from the Fed or Treasury.
So here we are, four years from when it was first announced that Libor was fiction and with no credible replacement in sight, when Libor was supposed to be replaced this year. However, what is absurd are situations like this one highlighted by this analyst:
“Libor tends to lag CP, it is not surprising that this spread has widened out as CP rates have dropped sharply,” Morgan Stanley strategists, including Kelcie Gerson, wrote in a note to clients about the gap between the two. They expect further tightening in the spread between Libor and overnight index swaps in a catch-up move to lower commercial paper rates.
This seems like otherwise very smart people are treating Libor like Santa Claus or the Easter Bunny. Libor is a make-believe rate. Therefore, why is a make-believe rate lagging commercial paper or real market rates with the same tenor and credit risk? Currently, the Fed is paying banks 15 basis points on excess reserves left in their Federal Reserve accounts overnight. On Friday, three-month Libor set at 12.8 basis points. How does one rationalize that a three-month rate with some credit risk commands a lower yield than an overnight rate with the safest counterparty on the planet? It seems the market has not yet come to grips with the fact that Libor is primarily based on what it set at the day before and the day before. Libor is auto-regressive. If I owned an asset that receives Libor, I’d be a little ticked off that this farce continues unabated and allowed to continue for far too long.
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