Streetwise Professor

August 8, 2012

Gary Gensler, Naked and Exposed

Maybe that’s a disturbing mental image, but the title is more than apt given Gensler’s recent NYT oped, “Libor, Naked and Exposed.”  As is his wont, demonstrated repeatedly on Frankendodd-related issues such as clearing and SEF mandates, Gensler presents a misleading and distorted analysis to advance some regulatory or political agenda.

Gensler questions the integrity of Libor.  This is certainly understandable in the light of the deluge of revelations in the past couple of months.  But the “evidence” that Gensler uses to justify his skepticism is completely off point, and certainly grossly overstates the impact of any manipulation on this important benchmark rate.

The first comparison Gensler makes is between Libor and Euribor.  He notes that dollar Euribor is about double dollar Libor.  But what Gensler omits to say is that this is an apples to horse apples comparison, given the major differences between the banks in the Libor and Euribor panels.  The former includes major banks (crucially, TBTF banks that benefit from the implicit and explicit support of governments and central banks), and most notably major US banks with ready access to dollar funding.  The latter includes something of a dog’s breakfast of foreign banks.  It has two Spanish and one Portuguese cajas and five German landesbanken, for crissakes.  And Dexia! The Euribor panel banks are all weaker, and don’t benefit from the same safety net as the banks in the Libor panel.  Moreover, since the beginning of the crisis, foreign banks have much greater difficulty in securing dollar funding than US banks.  Even big European banks (such as French giants like Paribas)  have faced acute dollar funding problems.  This is one reason why they have been deleveraging, and selling off dollar assets.  The Euribor banks almost certainly have even worse problems.

This issue of fragmentation of funding markets also bears on Gensler’s second piece of evidence: the divergence between Libor and the dollar rate implicit in FX swap prices. Gensler treats the violation of the interest rate parity relation as an indicia of manipulation.

But again, this reflects the acute problems European banks have faced in securing dollar funding.  They can borrow in Euros, but have to swap it into dollars to fund their dollar assets.  They are willing to, and the market is making them, pay a premium to execute this transaction.

Gensler claims “this divergence between theory and practice has yet to be adequately explained.”  Really?  It is well-understood.  Don’t believe me?  How about some economists from the New York Fed?  They investigated this issue in detail in 2009, and concluded that the divergence in the basis between the FX swap implied USD rate and USD Libor was caused by the dislocations associated with the financial crisis.

Indeed, Gensler’s oped implicitly recognizes this: he notes that implied and Libor rates have not been aligned “since 2008.”  Hmm.  What happened in 2008?  Think, think, think.  A financial crisis maybe?  Could that be it?  I’m thinkin’.

One key piece of evidence that FRBNY economists  Coffey, Hrung, Nguyen, and Sakar present is that the basis blowout was not limited to Libor.  It was also present when they used the New York Funding Rate produced by ICAP.  It was also present when they used Eurodollar deposit rates.

Look, anybody who has followed this knows that basis relationships that had been steady as a rock for years went haywire starting in August, 2007.  (Happy Anniversary!)  The CDS-cash bond basis went haywire.  Interest rate spreads (e.g., OIS-Libor) went haywire.  Spreads between borrowing rates across banks have become much more dispersed and become much more volatile.  (This relates directly to the Euribor-Libor comparison: banks are much more heterogeneous now than in, say, 2006, making comparisons between averages across different groups of banks much less meaningful now than then.)

This pertains to another piece of evidence: the lack of comovement between bank CDS spreads and their Libor submissions.  This could be informative, particularly in normal times, but it is problematic during crisis times.  CDS spreads and yields on the underlying cash bonds diverged dramatically, and often exhibited little comovement, during the period of the crisis.  CDS spreads were being driven by liquidity and risk aversion issues.  If the CDS-cash bond basis became much more volatile, it’s not at all surprising that the CDS-Libor spread also became much more variable, given that CDS and cash bonds have closer kinship than CDS and unsecured short term borrowings.

Noticing a pattern here? Basis relationships of every sort became much more volatile during the crisis period, and hence are far less reliable evidence of manipulation in Libor than would have been the case more than 5 years ago.  In essence, Gensler is trying to tell time with a broken watch.

Recall that Gensler mentions “the divergence between theory and practice.”  Anybody who has been paying attention understands why that’s true.  The theory is predicated on an assumption of frictionless financial markets.  Financial markets where capital and liquidity constraints are not binding, thereby permitting arbitrageurs to eliminate swiftly divergences in prices across related markets.  That was a reasonable approximation of reality in say, July, 2007: certainly in July, 2005.  It is completely unreasonable post-August, 2007.

Or as the FRBNY economists put it:

The widening of the basis illustrates the breakdown in arbitrage relationships that has afflicted many markets during the financial crisis. For example, eurodollar interest rates in New York and London diverged during the crisis-as did yields on corporate bonds and credit default swaps, which are closely related securities.  The element common to all of these phenomena was increased funding costs, which impeded arbitrageurs from shrinking the basis between these types of securities.  In addition, counterparty credit risk became prominent, and previously risk-free arbitrage trades suddenly became risky . . . funding constraints and counterparty risk explain the rise in the basis and the relative importance of each factor changed as the crisis evolved. [Emphasis added].

Since then, the coefficient of financial friction has reached record levels.  Capital and liquidity and funding constraints are binding everywhere, and binding hard.  In particular funding markets-and Libor is a measure of a funding costs for some banks-have been dysfunctional for 5 years.  Severely dysfunctional.  Most of the European banking system relies on the ECB for funding.  Markets across regions that were once highly integrated are now fragmented as never before.

This is particularly important for dollars.  Having access to dollar funding via deposits and access to the Fed (like major US banks) is completely different than having to raise dollars through wholesale markets, like most European banks that have been hit hard by the flight of US money market funds and other sources of dollar liquidity.  This is what drives things like the Euribor-Libor differential, and the swap-Libor basis.

Hell, there is fragmentation of funding even within currency areas, in particular, the Eurozone.  European subsidiaries are attempting to fund their local lending with local deposits, especially in countries where conversion risk (i.e., the risk that a country will leave the Euro) is acute.  For instance, Italian subsidiaries of French banks are funding their loans to Italian businesses with local deposits, rather than money from the parent banks.

In other words, Gensler is relying on a textbook model that presumes a frictionless world.  That ain’t our world, today.  The textbook needs to be thrown out.  But Gensler uses it as his bible.

There are two explanations of this, both quite frightening.

The first is that he really doesn’t understand this.  That he doesn’t understand that the financial system has suffered cataclysmic shocks and doesn’t work the way it used to.   It would inspire confidence, wouldn’t it, that an individual playing a crucial role in reshaping that financial system through the promulgation of rules under Frankendodd doesn’t understand why things are working-or not working-the way they are?

The second is that he is a fan of the band Say Anything.  That he knows that his “evidence” has nothing to do with Libor manipulation, but he is saying it to advance some regulatory or political agenda.

I’m betting on the second alternative, because Gensler is a serial offender in this: look back at my posts from 2009 and 2010 and you will see numerous times where I called BS on the former Goldman managing director for making ludicrous statements about financial markets-all of which were calculated to justify Frankendodd and a massive expansion of Federal regulation of derivatives markets.

Regardless of the reason, one thing is clear: Gensler’s misleading analysis lies naked and exposed. This is not to say that Libor was not manipulated.  It is to say that what Gensler hypes is not evidence of the existence of manipulation, or the magnitude of its effect.

It is unfortunate that he penned such a distorted oped, given that his agency provided a very rational proposal to reform the Libor fixing process in its Barclay’s settlement order.   Gensler should limit himself to promoting that proposal, rather than writing pieces that sow confusion and promote misunderstanding about a highly contentious issue that could have huge and costly impacts on banks-and hence on the world financial system, stressed as it already is.  That is not constructive.  It is irresponsible and dangerous.

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  1. […] Gary Gensler’s distorted analysis of the Libor […]

    Pingback by FT Alphaville » Further reading — August 9, 2012 @ 1:30 am

  2. Good post, Prof. I’d offer a third + fourth alternative: 3) Gensler’s staff economists likely did the write-up for him, under his direction. They likely are familiar with the zero-friction theoretical assumptions of most models, and likely made the case the markets are violating the fundamental conventions of arb theory. This is like red meat for a guy with an agenda. Nonetheless, it exposes one of two things: a)their inability to comprehend what’s going on in the markets they’re supposed to be knowledgeable about; b) a predisposition to intellectual dishonesty, and a willingness to provide the fodder for polemics vs economics. 4) A combination of all the above — your 1 + 2, plus 3 + 4 here. Incomprehension at the top; an aggressive agenda; incomprehension and incompetence at the staff level, or intellectual dishonesty. Taken together, a disturbing picture.

    Comment by markets.aurelius — August 9, 2012 @ 10:24 am

  3. Not Good but a great post! (how is that for sucking up?) I would like to offer a fifth – that either by design or self inflicted memory loss, this is part of his “Promote GG to higher office campaign” Anyone can convince themselves of anything if it is in their interest – this sounds like a position paper / resume filler if the great ignoramus gets reelected.

    Comment by sotos — August 9, 2012 @ 12:41 pm

  4. @sotos. Thanks! Excellent job sucking up! (How’s that for sucking up about sucking up :-P). I definitely think that this is part of the GiGi campaign for higher office (SecTreas, most likely). I think this explanation is complementary to @markets’ “guy with an agenda” explanation.

    @markets-Thank you too. (Even though you were more understated than @sotos :-P). Definitely a disturbing picture. Definitely. I’ve been disturbed for going on 4 years now.

    The ProfessorComment by The Professor — August 9, 2012 @ 1:39 pm

  5. Professor: You’d make Karl Popper proud..
    Gary Gensler as everyone else who has been looking at the XCCY basis as its called is implicitly
    aware that they are violating the very strongest aribitrage constraint in financial markets..

    If Interest parity does not hold… then you can’t price the forwards… and if you can’t price the forwards….. What everyone who “trades” and thinks about these things comes to a different conclusion..

    Interest parity holds… In one marketplace.. the FX marketplace.. where the same Banks at least for the LIBOR panel…still have access to FX forwards… when push comes to shove even today they have to pay
    around 40 bp’s more for “3 month Libor”… than the “bogus” BBAM FIX…

    And back a year or so ago it was close to 1.60% more than 3 month LIBOR..

    There is no distortion.. Those that know best… “other banks” demand a substantial premium to lend any money to what is called “le bad French Banque”…

    How does all this come back to LIBOR “irrelevancy”… The BBAM panel is basically an opinion poll..
    where each Bank seeks to convey where it thinks it can I imagine fund 3 month depo’s..

    Even today as anyone who looks at the Numbers (FED economists aside) …The Libor “fix”
    is around .40%… the 3 month XCCY basis is around 37 bp’s… thats… .77%… which is
    where the “real market” which trades even today billions…effectively will “lend” LIBOR to “le bad banques”..

    this is so obvious.. to all.. that when one looks at the distribution of 3 month LIBOR… as opposed
    to the turncated mean.. that the BBAM uses… Soc Gen shows an offer of .58..

    Close to 20 bp’s above the LIBOR mean… but still 20 bp’s lower than where the real world assumes they
    can Fund…

    A year ago.. this differential is/was nearly 200 basis points…

    Now as Gary Gensler and everyone else included the FED knew… using a combination of where the XCCY was
    where the ECB would lend to a Bank.. (including haircut) etc… One could and would be able to derive
    the markets “derived” cost of capital for the representative bank that was forced to borrow.. at
    say 160 to 200 basis points over the risk free rate..

    Oh yes I fogot…recognizing that Libor has for years been an irrelevancy… the market has shifted to an
    OIS.. basis.. today for example Libor is around 25 bp’s above OIS.. .
    and XCCY of say 35 bp’s… means that in the FX marketplace… “bad banks” are willing to pay
    35 bp’s +25 bp’s.. or roughly 60 basis points above OIS to fund themselves in dollars…

    Long story short:.. If there was a real candidate for where 3 month LIBOR really traded…
    the answer is simple… For those without unencumbered acess to OIS.. (which recall
    itself is a “risky rate”… the rate at which Banks in the US exchange reserves..

    If your not lucky enough to be one of those Banks… then a good estimate is that it cost you
    60 basis points more than OIS to fund..

    Not the 25 basis points over OIS that the BBAM “advertises”..

    While FED economists may have their own opinions.. Mr. Bernanke and others understood this explicitly..
    which is why in December of 2011… the reduced the ECB swap rate (the rate at which the FED would
    lend to the ECB essentially) to 50 bp’s over OIS…

    If one were in a philosphical frame of mind.. One could say that the FED through their actions..
    aided the course of “financial repression”… by “artifically offer” to lend money to the worst
    banks at an spread of OIS plus 50 bp’s..

    Compare this to the Justice department data where people are trying to reset the fixing by 1 bp’s…

    They and “everyone” else understood.. that this would immediately drive the XCCY..from over 100 to
    its current 60 bp’s over OIS… and…by definition collapse LIBOR…even for the worst Bank..

    Back to Popper… The basic mistake is to believe that frictions exist… to “screw up the model”..
    in physics as Gallelio showed this is the way to go… but not in finance..

    In finance… its the “frictions” that have to be explained…and here the frictions show.. the simple divergence between where One man says he can borrow… and where the market as a whole answers..

    All I know is if I was an Investor who had agreed to lend money to one of these guys at LIBOR…5 years ago… I would have assumed that LIBOR would reflect the “risk premium” in the marketplace… so
    that my floating rate security would compensate me for the risk that I took..

    I’d be a bit annoyed to find that I’m being deprived of that compensation…because the contract
    that I negotiated enabled the “borrower”.. to “arbitrarily” set the rate which he would pay me
    in the future

    Comment by stan jonas — August 9, 2012 @ 4:10 pm

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