Libor: trustworthy?

[campbell]

From the front page of the WSJ this morning:
http://online.wsj.com/article/SB1208..._us_whats_news

LIBOR FOG
Bankers Cast Doubt
On Key Rate Amid Crisis
By CARRICK MOLLENKAMP
April 16, 2008; Page A1

LONDON -- One of the most important barometers of the world's financial health could be sending false signals.

In a development that has implications for borrowers everywhere, from Russian oil producers to homeowners in Detroit, bankers and traders are expressing concerns that the London inter-bank offered rate, known as Libor, is becoming unreliable.

....

The concern: Some banks don't want to report the high rates they're paying for short-term loans because they don't want to tip off the market that they're desperate for cash. The Libor system depends on banks to tell the truth about their borrowing rates. Fibbing by banks could mean that millions of borrowers around the world are paying artificially low rates on their loans. That's good for borrowers, but could be very bad for the banks and other financial institutions that lend to them.

....
In one sign of increasing concern about Libor, traders and banks are considering using other benchmarks to calculate interest rates, according to several traders. Among the candidates: rates set by central banks for loans, and rates on so-called repurchase agreements, under which borrowers provide banks with securities as collateral for short-term loans.

In a report published in March by the Bank for International Settlements, economists Jacob Gyntelberg and Philip Wooldridge raised concerns that banks might report incorrect rate information. The report said that banks might have an incentive to provide false rates to profit from derivatives transactions. The report said that although the practice of throwing out the lowest and highest groups of quotes is likely to curb manipulation, Libor rates can still "be manipulated if contributor banks collude or if a sufficient number change their behaviour."

This reminds me of my reaction to learning about arbitrage-free/risk-neutral pricing based on "risk-free" interest rates: there's no such thing as risk-free. Just less risky (in a particular dimension).

[tenthring]

IMO this is the scariest thing in the credit crisis thus far. Even scarier then Bear.

I'll get the office's copy of Tuesday's WSJ on Friday, I'll have to read it this weekend to see exactly what it says.

[campbell]

(IB: this was in the Wednesday issue of the WSJ)

What I'm posting below comes from today's (Friday April 18) Wall Street Journal:
http://online.wsj.com/article/SB1208..._us_whats_news

Libor Surges After Scrutiny Does, Too
Banks May Be Reacting
As BBA Speeds Probe;
Impact on Borrowers
By CARRICK MOLLENKAMP
April 18, 2008; Page C1

LONDON -- The world's most widely used interest rate took its largest jump since the advent of the credit crisis in a sign that banks could be responding to increasing concerns that the rate doesn't reflect their actual borrowing costs.


Thursday's sudden jump in the dollar-denominated London interbank offered rate, or Libor, comes after a decision Wednesday by the British Bankers' Association to speed up an inquiry into the daily borrowing rates that banks provide to establish the Libor rate.


The move by the BBA, which oversees Libor, came amid concerns among bankers that their rivals were not reporting the high rates they were paying for short-term loans for fear of appearing desperate for cash.

....


Some expect Libor to increase further. William Porter, credit strategist at Credit Suisse, said he believes the three-month dollar rate is 0.4 percentage point below where it should be. That echoes the view of Scott Peng, a Citigroup Inc. analyst who said that Libor understated banks' true borrowing costs by as much as 0.3 percentage points.

The benchmark dollar Libor rate for three-month borrowing hit 2.8175% Thursday, or about .08 percentage point more than the 2.7335% rate set on Wednesday. That was the biggest increase since the three-month rate rose 0.12 percentage point on Aug. 9. At that time, news that French bank BNP Paribas had suspended withdrawals from three investment funds set off global concerns about banks' financial health. The three-month rate is now at its highest level since March 13, when markets were preoccupied with problems at Bear Stearns Co.

[JMO]

Do I hear an echo of someone saying, "Trust, but verify"?

[A Student]

My ARM is set off Libor, let'em low ball!!

(J/K - I understand the massive problems that occur if this rate is manipulated.)

[campbell]

Followup from the WSJ:
Study casts doubt on key rate May 29, 2008 pg A1

LONDON -- 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.

Click on the interactive pop-up window -- can see where Libor diverges from the default insurance-based estimate. I wish they pushed it back farther than April 2007 for the graphs - I want to see if this divergence happens more often in times of high interest rate volatility (which wouldn't surprise me in the least). I'm going to write them about that.

[campbell]

FWIW, I emailed the authors of that article, asking for some followup. I don't expect to get an answer directly, but I'm hoping for coverage along these lines:

Thank you for this morning’s article on Libor. I have been following this since the “Libor Fog” article in April – this is an extremely important issue to those of us in the financial services business.



I have some questions regarding this issue, that I do not recall reading in previous coverage:



1. Is kicking out a member bank the only penalty the BBA can levy on a bank falsifying rate data? What are the practical repercussions for a bank not being in the BBA?




2. What kind of data reliability controls did the BBA have in effect (or even now has in effect) to prevent false reporting? Do they just take the rates as reported, do their average, and just not worry about it?






3. According to this morning’s article, many of the reported rates are estimates, in that the bank isn’t actively borrowing money at given durations and thus make up some number to give to the BBA. When companies report the rates to the BBA, are they supposed to indicate which were real rates and which were estimates? If so, could this be incorporated into the WSJ analysis?




For all the vaunted transparency of the BBA’s process to get Libor, the coverage from the WSJ so far has not inspired much confidence in the data controls of the BBA. The analysis done by the WSJ could just as easily have been done by the BBA in protecting the reliability of their indicators. Perhaps they have such processes in place, and it would be nice to know of them. If you have covered these issues in a previous article, could you send me a link.





4. Could y’all extend the analysis of Libor/default-insurance-based rates divergence back more years? It’s difficult to analyze the behavior of the divergence given that the period shown where the two rates are equal is a time of very low rate volatility. I would like to see the behavior during another time of great interest rate movement – it could very well be that in times of high market volatility, measures of risk diverge greatly, without any falsification involved. Or perhaps this sort of behavior has been going on in Libor for many years, and users of this rate did not realize it until the WSJ coverage.


At this point, I want to know if this is only a recent development, or if this has occurred before. I imagine the WSJ could get a hold of more than one years’ worth of data.

If anybody here knows the answers to these questions, I would like to know.

[campbell]

The saga continues:
today's WSJ, page C2 - Changes to Libor Rejected:

LONDON -- After nearly two months of deliberations, the British Bankers' Association rejected many of the proposals aimed at addressing concerns about the accuracy of its benchmark interest rate, known as the London interbank offered rate, or Libor.


The BBA said it had decided against establishing an added dollar Libor rate to better capture the U.S. market, and would make no changes to the definition of Libor, which is supposed to reflect the short-term rates at which banks lend to one another.


The association also left in limbo a plan to expand the panels of banks that report their borrowing costs to calculate Libor every weekday morning in London.

The BBA will, however, consider setting up an additional rate designed to reflect the cost of borrowing dollars in Europe, and will move ahead with plans to better police the borrowing rates that banks contribute.

[Run2standstill]

After the LIBOR saga first emerged in April, market participants began to keep an eye on LIBOR's credibility and change pattern rather than taking the rates as a give. It is useful to take a look the current methods to varify whether LIBOR rates make sense.

1: FED TAF Auction Rates.

The weekly Fed TAF auction rate should be the 1st benchmark for LIBOR rates. The auction rate, under normal circumstances, should be very close to slighly lower than LIBOR rates. In the event that the auction being a holiday in London, the auction rate could be slightly higher (on average about 1 bp in the past).

2: Fed Eurodollar Deposit

Fed books the ED lending rate by taking the ICAP brokers' bid at 9:30 am EST or 2:30 pm London time. It is an offer rate for govmt security, so once again it should be close but little less than LIBOR. If LIBOR falls lower like in March - April, then it raises a flag. This is benchmark No.2.

3: Short-dated cross-currency swap spread

In a free market, the cross basis spread would be close to 0 because banks can borrow directly and freely for most major currencies. However, in April, the basis spread has widened dramatically (negative basis). One possible cause linked to LIBOR is banks cannot borrow USD at the published LIBOR rates, so they had to borrow heavily the local currency and then carry a cross currency swap to creat a synthetic USD loan. So this is the check no.3 by looking closely at the currency swap basis.