The US economy is about to pay the butcher’s bill for a massive disruption of worldwide financial markets resulting from the elimination of the London Interbank Offered Rate, or LIBOR. And, we are doing this on purpose. It seems the denizens of the heights of our international financial fabric felt they had to do this in light of the discovery that a handful of bankers had unlawfully colluded to cause LIBOR to be mispriced for their personal advantage. As Captain Renault said, “I’m shocked, shocked!” This was so bad that we had to blow up the LIBOR index upon which trillions of dollars of financial assets are based? While bankers behaving badly is a problem, why are we punishing markets because our banking regulatory cadres failed to prevent bad behavior? At best, this is a monument to irrational rectitude.
A little perspective.
LIBOR underpins something north of $300 trillion of financial assets around the world. We are now going to replace it with a new index, an index both untested and ill-suited to support the financial transactions now based on LIBOR. At the heart of this kerfuffle was the broad dissemination of the news that LIBOR is based on models and windage and largely not on market transactions. It’s a made up rate. But very few people without a Secret Decoder Ring actually knew that.
LIBOR is defined as the arithmetic mean of the interest rate at which major banks in the London market believe they could borrow from each other…if they did actually borrow from each other. But largely they don’t. On many days, there are few, if any, observable underlying transactions tied to the actual LIBOR submissions that are made by the panel banks which provide quotes to come up with the rate. Market participants have always known that LIBOR wasn’t perfect, that it was literally a fabrication based on a model and good guessing. But it has worked pretty well for the past many decades. At the end of the day, it seemed to generally reflect some sort of an agreed baseline notion of macro risk in the economy, and that’s what it was intended to do.
Then some bankers decided to alter this made-up rate for their own pecuniary benefit and got caught. Putting aside the astonishing mental gyrations required to convict a banker for faking a fake rate, couldn’t we just punish the bankers, reinforce prudential regulation and move on? No!
We were apparently so offended (or embarrassed) that we threw the LIBOR baby out with the unscrupulous bath water.
So the panjandrum of the world financial markets bent their mighty intellect to the problem and, here in the United States, we’ve become hell bent on replacing LIBOR with something called the Secured Overnight Financing Rate or SOFR. This is a rate that the Federal Reserve Bank of New York began publishing a few years ago and it reflects the cost of overnight repurchase agreements on Treasury instruments. The good news is that it is based only on observable data, so no more diddling bankers. The bad news is that it’s not representative of the baseline macro risk which was the hallmark of LIBOR. Using it will misprice every financial asset on which it is based.
In other words, as currently conceived, SOFR doesn’t really work. And the fact that it doesn’t work doesn’t seem to be bothering the denizens of the heights all that much. SOFR has been anointed and now legions of wonks, academics and bureaucrats, have been beavering away on transition and even that is proving to be supremely difficult. The New York Fed, working through a private consortium called the Alternative Reference Rates Committee (ARRC), having selected SOFR has now published proposed transition language, language which is turgid and operationally difficult to use.
Many important people seem to be succeeding at not thinking about the problems of moving the billions, if not trillions, of dollars of assets which will still be priced on LIBOR to SOFR when LIBOR goes away. If transition sucks, get over it. Life will be great on the other side. I’ve heard the transition problems dismissed as whinging. Millions of individual contracts and tens of thousands of counterparties are going to have to change the crux of their financial contracts: the cost of the money. Think there’ll be some problems? A wee bit of litigation perhaps? We will now spend millions and perhaps even billions of dollars transitioning financial assets to the new index, fighting over the transition, building systems to support the new index, and remember, post transition the new index doesn’t really work. More on that later.
Why are we doing this? We caught the bad guys. Shouldn’t we just fix the problem by making sure it doesn’t happen again? No! Let’s blow the whole damn thing up. This is like being offended at the inefficiencies of the local volunteer fire department and burning one’s house down in protest.
Maybe this is all about embarrassed regulators who got fooled by misbehaving bankers, but I suspect it’s about the principle of the thing; that we need to right a wrong. That should make us very worried indeed. We’ve done a lot of stupid things in the name of principle (Iraq War anyone?) and we’ve been doing it for a long time. Let’s go back a few centuries. The pursuit of virtue untethered from common sense or a sense of proportion rarely results in good outcomes. When Pope Innocent III’s troops invested the Cathar infested town of Béziers, they faced a conundrum. How to tell the good Christians from the Cathari? The Pope’s guy on site reportedly said, “Kill them all. God will recognize His own.” I suspect the good citizens of Béziers didn’t appreciate the logic of the approach, and I guarantee market participants all across the world are not going to appreciate governmental and regulatory elites blowing up our financial system out of a sense of moral indignation that the system had been played.
And call me silly, but we didn’t have to do this. What about just requiring regulators to do a better job than what they’ve done in the past, redoubling their efforts to ensure that no one commits fraud? What about requiring the money center banks to establish and manage a market of interbank lending which would give us observable data? What about… I don’t know, they’re the brain trusts, think of something that would have preserved the LIBOR structure that has underpinned our economy for decades. Is that so outrageous?
This is crucially important because, at the end of the day, after transition is a bad memory, SOFR still won’t work. As SOFR is currently drafted, the risk premium adjustment contemplated between LIBOR and SOFR is not dynamic. It is set on a specific day and never moves. That assures that over the tenor of financial assets priced on the new SOFR index that there will be a transfer of value from the provider of capital to the user of capital or vice versa. How in the world does that make sense? SOFR then misprices credit and it will impair the ability of the banking system to make loans. That, I thought, was the point of this whole banking system thing.