The American Mind

Just when the financial industry was working through the uncertainty of housing and mortgage problems the Wall Street Journal makes a great case banks have been lying to a banking organization that sets a key interest rate marker, the London interbank offered rate (Libor):

Major banks are contributing to the erratic behavior of a crucial global lending benchmark, a Wall Street Journal analysis shows.

The Journal analysis indicates that Citigroup Inc., WestLB, HBOS PLC, J.P. Morgan Chase & Co. and UBS AG are among the banks that have been reporting significantly lower borrowing costs for the London interbank offered rate, or Libor, than what another market measure suggests they should be. Those five banks are members of a 16-bank panel that reports rates used to calculate Libor in dollars.

That has led Libor, which is supposed to reflect the average rate at which banks lend to each other, to act as if the banking system was doing better than it was at critical junctures in the financial crisis. The reliability of Libor is crucial to consumers and businesses around the world, because the benchmark is used by lenders to set interest rates on everything from home mortgages to corporate loans.

There are some like Felix Salmon that don’t buy the WSJ analysis:

But my gut reaction that the methodology is flawed was based on none of those. Rather, I mistrust any calculation which assumes that since last summer there has been a clean and predictable and precise relationship between cash credit products, on the one hand, and credit default swaps, on the other. Yes, Libor is a borrowing rate, and yes, there is some kind of credit spread baked in to it. But to assume that Libor equals a risk-free borrowing rate plus a default-risk premium is silly and simplistic - especially when you don’t back-test your model to a time when things were much less volatile.

What convinced me something fishy was up was Libor rates lined up closer to the credit-default swaps market after the WSJ reported in April there were questions about Libor’s accuracy.

It’s theorized the banks may have mistated their borrowing rates to hide how tough their business really was/is. Although it echoes Adam Smith:

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

Only in this case prices weren’t raised. An inaccurate Libor number wasn’t bad for those with adjustable-rate mortgages. Their payments weren’t as high as they could have been. Who was hurt were investors of securities with rates based on Libor. A hedge fund manager told the WSJ that he could be out $500,000 dollars so far this year.

Now before people (especially Congressional Democrats) start screaming for new regulations the market is already adjusting:

The questions about Libor have caused Robert Fuller, head of New Jersey’s Capital Markets Management LLC, to begin thinking about using other benchmarks. Mr. Fuller, who consults with hospitals, schools and governments about interest-rate swaps, says he is considering using the federal-funds rate — the rate at which banks loan to each other overnight — in swaps contracts.

“I am thinking very carefully about how to proceed, and I do think most of the swap community is doing the same,” he says. “I would definitely consider doing something like fed funds or anything else that the industry has that’s nonmanipulable.”

London brokerage ICAP is in the process of launching a new way to measure the rate at which banks borrow money — an anonymous survey of some 40 banks it plans to call the New York Funding Rate. Participating banks wouldn’t have to worry about the stigma of reporting high rates. The planned survey would cover a wide range of markets, not just interbank loans.

Also, the Libor rose today, the first day after the WSJ report.

“Study Casts Doubt on Key Rate“