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John Mauldin: A Different Take on LIBOR


We need to consider how we should organize our financial world.

This article was originally published on July 28 in John Mauldin's weekly e-letter.

Rick: How can you close me up? On what grounds?
Captain Renault: I'm shocked, shocked to find that gambling is going on in here!

– From the classic scene in Casablanca, made in 1942

The latest scandal du jour seems to be about what is now called LIBORgate. But is it a scandal or is it really just business as usual? And if we don't know which it is, what does that say about how we organize the financial world, in which $300-800 trillion, give or take, is based on LIBOR? This is actually just the second verse of the old song about derivatives, which is a much larger market. Which of course is a problem that was not solved by Dodd-Frank and that has the potential to once again create true havoc with the markets, whereas LIBOR can only cost a few billion here and there. (Sarcasm intended.)

The problem is the lack of transparency. Why would banks want to reveal how much profit they are making? The last thing they want is transparency. This week I offer a different take on LIBOR, one which may annoy a few readers, but which I hope provokes some thinking about how we should organize our financial world.

There Is Gambling in the House? I Am Shocked...

Let's quickly look at what LIBOR is. The initials stand for London InterBank Offered Rate. It is the rate that is based on what 16 banks based in London (some are US banks) tell Thomson Reuters they expect to pay for overnight loans (and other longer loans). Thomson Reuters throws out the highest four numbers and the lowest four numbers and then gives us an average of the rest. Then that averaged number becomes about 150 other "rates," from overnight to one year and in different currencies. The key is that the number is not what the banks actually paid for loans, it's what they expect to pay. Also, please note that the British Banking Association, on its official website, calls this a price "fixing."

Most of the time the number is probably pretty close to real, or close enough for government work. But then, there are other times when it is at best a guess and at worst manipulated.

Back in the banking and credit crisis panic of 2008 the interbank market dried up. No bank was loaning other banks any money at any price. Thus there was clearly no way for the LIBOR number to be anything but fictitious. Anyone who was not aware of this was simply not paying attention.

The regulators certainly knew on both sides of the Atlantic. All along there were clear records, we now learn, that bankers were telling the FSA (the Financial Services Authority) that they had problems. Regulators were worried about what was happening but were pointing out that there was a large hole in the ship that was already admitting water, and they didn't want to make it any bigger. Timothy Geithner, then President of the New York Federal Reserve Bank (and now Secretary of the Treasury) wrote a rather pointed letter to the FSA, suggesting the need for better practices.

Some banks reported lower rates, to make it appear they were better off than they were (since no one was actually lending to them), and others might have given higher rates, for other reasons. Remember, this was a British Banking Association number. Whether you personally won or lost money on the probably wrong price information depends on whether you were lending or borrowing and whether you really wanted the entire market to appear worse than it already was.

This was the equivalent of an open-book test where you got to grade your own paper. And we are supposed to be shocked that there might have been a few bad "expectations" here and there by bankers acting in their own self-interest, with the knowledge of the regulators? The more amazing proposition would be that in a time of crisis the number had any close bearing on reality to begin with. Call me skeptical, but I fail to see how we should be surprised.

The larger question that really needs to be asked is how in the name of all that is holy did we get to a place where we base hundreds of trillions of dollars of transactions worldwide on a number whose provenance is not clearly transparent. Yes, I get that the methodology of the creation of the number after the banks call in their "expectations" is clear, but the process of getting to that number was evidently not well understood and looks to be even muddier than my rather cynical previous understanding of it.

It now seems that there will be a feeding frenzy as politicians and regulators hammer the various banks for improper practices. And they are pretty easy targets: there is just no way you can explain this that does not sound bad.

You're a big banker. The world is falling down before your eyes. No one trusts anyone. If you put out a bad number (whatever "bad" means in a time of sheer utter blind panic) the markets will kill you even more than they already are and you could lose your job. You have got to come up with a number in ten minutes.

"Hey, Nigel, what do you think we should tell Tommie [Thomson Reuters]?"

"I don't know, Winthorpe, maybe Mortimer has an idea; let's ask him."

Simply fining a few bankers is not going to fix the larger problem: the lack of transparency for arguably the most important number in financial markets. A very clear methodology needs to be developed, along with guidelines for what to do in times of crisis when the interbank market is frozen and there really is no number. Having no number might be worse than having a number that is a guess. But having a number that can be fudged by banks for their benefit is also clearly not in the public's interest.

The point of the rule of law is that it is supposed to level the playing field. But the rule of law means having a very transparent process with very clear rules and guidelines and penalties for breaking the rules.

I had dinner with Dr. Woody Brock this evening in Rockport. We were discussing this issue and he mentioned that he had done a study based on analysis by an institution that looks at all sorts of "fuzzy" data, like how easy it is to start a business in a country, corporate taxes and business structures, levels of free trade and free markets, and the legal system. It turned out that the trait that was most positively correlated with GDP growth was strength of the rule of law. It is also one of the major factors that Niall Ferguson cites in his book Civilization as a reason for the ascendency of the West in the last 500 years, and a factor that helps explain why China is rising again as it emerges from chaos.

One of the very real problems we face is the growing feeling that the system is rigged against regular people in favor of "the bankers" or the 1%. And if we are honest with ourselves, we have to admit there is reason for that feeling. Things like LIBOR are structured with a very real potential for manipulation. When the facts come out, there is just one more reason not to trust the system. And if there is no trust, there is no system.

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