Odd Lots - The World's Most Controversial Interest Rate Is Haunting Us Again

Episode Date: March 26, 2018

Remember LIBOR? The London Interbank Offered Rate measures the cost of money when banks borrow from each other. It famously blew out during the financial crisis, but for a long time since then it's been dormant. Only lately it's started to creep higher again. On this week's Odd Lots podcast, we talk to Scott Peng, the founder, CEO and CIO of Advocate Capital Management, who warned in early 2008 that there was something fishy about the way the measure was being priced. In the post-crisis period, it was discovered that the rate -- which helps price trillions of dollars worth of other assets -- was being gamed or manipulated by traders. Peng walks us through the history of the rate, what it's telling us now, and what may ultimately replace it. See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. And welcome to another edition of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, do you remember LIBOR? I think I remember that. Yes, I do.

What was that again? A loaded question. LIBOR, the London Interbank offered rate. Basically, the rate at which banks lend money to each other. It was a big LIBOR scandal, right? Yeah. I mean, there's so much. could say about LIBOR. So it became a big deal during the financial crisis because the rate blew out

because basically all these banks didn't want to lend money to each other. So they had to offer a higher rate in order to do it. And then after the financial crisis, we found out that LIBOR had been rigged in various ways. And that's because the way LIBOR actually works is it was done by survey. So someone would actually go to the banks and collect their estimates of LIBOR each day and then they would come up with a sort of aggregate. So it was a self-reported rate that ended up being manipulated by some of the people that were reporting it. I was so shocked when it turned out that it was manipulated. Isn't the thing where they do the price literally called a fix? Yeah, that's right.

In retrospect. I can't believe that in retrospect, something called the fix. turned out to be manipulated. I was totally stunned by that. All right, we are all shocked. But I will tell you something that is actually shocking now, sort of. We are all expecting LIBOR to be phased out

at one point or another, relatively soon, actually, given what happened with the self-reporting scheme. It's supposed to be replaced by something that hopefully won't be as subject to manipulation. But just as LIBOR was about to be consigned to

to financial market history. It was about to die, right? It has come back from the dead effectively to haunt financial markets. Ooh, I'm intrigued. Yes. So we are going to call this episode Revenge of the LIBOR. And we have the perfect person to talk about all this, not just what happened in 2008 and then during the LIBOR manipulation scandal, but also to discuss what's happening now and why people

are once again discussing LIBOR. Let's do it. So our guest for this episode is Scott Peng. He is the CEO of Advocate Capital Management, and he also used to be head of U.S. interest rate strategy at Citigroup, a fact that will be relevant in just a few minutes. Scott, thanks so much for coming on. Thanks for having me, guys.

So I'm so glad we could have you do this, because you truly are the perfect person to talk about LIBOR, because you were one of the first people, if not the first person, to actually point out that it looked like LIBOR potentially was being manipulated in some way. Is that right? Yeah, and it's been a long and strange journey since that point. And I would sort of contend with the statement that LIBOR is dead because, you know, rumors of its death, as we'll discuss, are somewhat greatly exaggerated. So just to back up, Tracy mentioned in the intro, LIBOR being the rate that banks used to price short-term lending to one another. Just give us the sort of quick history of how this rate became a thing.

Sure. Before I started in the business in the 80s, the key short-term rate was actually not LIBOR. It was actually three-month treasury bills. LIBOR came along in the mid-80s as a way for non-U.S. Domiciled banks to obtain, financing in the Eurodollar market. And over time, with increased usage, with its center status in the middle of interest rate swaps, it took over the benchmark status from three-month T-bills, and it's been the benchmark since the late 80s, early 90s. So that was really the genesis of LIBOR. And at some point, maybe we'll have some time to touch back on that, because I think going back to three-month T bills may actually be a very useful thing in terms of considering

LIBOR replacements. Yeah, we're definitely going to talk about LIBOR replacements. But before we do, just to set the scene, remind us what LIBOR looked like, you know, in 2008 in the depths of the financial crisis, because we not only saw LIBOR blow out, we also measured LIBOR against OIS, the overnight index swaps, basically a risk-free rate of lending pegged to typically Fed Funds' futures. Walk us through the dynamics there. Why did we see that spread blow out? Well, the basic mechanics of LIBOR back then was there were 16 submission banks, and the LIBOR setters, which is the British Bankers Association, would take the four highest, four lowest, throw them out and average the rest.

and that process was supposed to eliminate any attempt at collusion. During the global financial crisis, bank funding costs started to rise, and LIBOR did begin to rise. However, because at that point, LIBOR rates submitted by each bank was published on sources like Bloomberg, people could see when the bank was vulnerable because they could see its LIBOR submissions start to rise, and people began looking very carefully at these LIBOR submissions. And that created an incentive on the part of many banks to begin to undercount the actual financing rate. And that really was the issue that we pointed out when we did our analysis on LIBOR in April of 2008. Can you explain a little bit that mechanism, the banks submit numbers based on what?

And then they throw some out. It sounds kind of like an Olympic scoring system of lopping off the edges. But just walk us through that process a little bit more. Sure. Banks are supposed to submit LIBOR based on where they are financed. And typically, the submission entity is supposed to be squared away in the middle of a bank's funding area. Over time, some of those supposedly walled off people and walled off entities began to be influenced by other parts of the trading desk. Very frequently, these submission entities and people sat on the same trading floor as traders who were taking positions on. where LIBOR or interest rates swaps are.

So over time, you started getting some influence from the traders who were market making and taking market positions, influencing the people who are actually setting the rates. So there were two reasons to manipulate LIBOR, right? Like, on the one hand, you could potentially help your portfolio, your colleagues at the bank, you know, help the positions depending on where you shifted LIBOR. But on the other hand, during the financial crisis, people were much more concerned about reputational risks.

So typically they started underreporting the LIBOR rate because they didn't want to make it look like there was a huge interbank lending crunch and that they were getting the worst of it. Is that right? Right. And the more noble goal, if you will, is to make your bank appear stronger than it would be and the more mundane goal would be for the traders to try to profit on ongoing basis

from these rate sets. Now, when I published my article, we're not able to get access to sort of the day-to-day manipulations that may have been going on. But what we could see is using publicly available data, we can start to see the discrepancy between where people are setting LIBOR versus where banks are actually funding. So that really was the genesis of my analysis that you can find this discrepancy from publicly available market data. So you said there's theoretically two different sort of strains of LIBOR manipulation. One would be designed to conceal the degree of vulnerability in the system overall, which because of self-fulfilling prophecies may in theoretically have been beneficial in some way.

And then the other is the more cynical manipulating the number so as to profit off of trades that are tied to the number. How big was or is the market for instruments that are in some way connected to LIBOR? I mean, LIBOR is tied into pretty much everything around us. We're talking about hundreds of trillions of notionals of interest rate swaps that directly refer to LIBOR. On top of that, you have bank loans, student loans, mortgages that are all indexed to a great variety of LIBOR. So, LIBOR is really an intricate part of our everyday lives. So, Scott, in I think it was April 2008, you published your report, Is LIBOR broken? What happened after that? Did you get a lot of backlash? I can't imagine your colleagues, even at Citibank, potentially, were that enthused about it.

Yeah, I mean, we wrote our analysis. We got sent out to clients, and it was kind of radio silence for about a five-day period. And then the Wall Street Journal picked it up and was on the front page and then all of a sudden all hell broke loose. So let's just say that I got called into quite a few meetings that day as a result of that. Who was the most upset about it when you say all hell broke loose? Where were you hearing that the most? We heard that BBA wasn't happy with us. We heard that management was not happy with us. The good thing was I sign off on the article with my boss, Michael Schumacher, of the same name as the race car driver, prior to the publication. So I knew he had my back. But there was a lot of political blowback from that. Because if you think about it, you know, again, LIBOR is so central to, you know,

everything and not just finance, but in the whole world, that, you know, calling the question was really a big deal. So I want to move on to what LIBOR is actually doing now and why we're all talking about it. But before we do, maybe just to sum up, after the financial crisis, we have an actual investigation into LIBOR and how it was said. What was the outcome of that investigation? I think the outcome was that a great many of the banks who involved in LIBOR sets were tainted. in their submission, whether it's on an ongoing basis or whether it's infrequently because of the influence of market makers and risk takers on the LIBOR submission side. So I think one of the key results is that now we have a new administrator for LIBOR. We have banks who have much

clearer policies in terms of the wall around the LIBOR setters and hopefully went a bit of a better place. I have one more question about LIBOR history before we move on. you touched on the important point, and one of the reasons the story resonated so much is because it touches all of our lives and so many of us have financial instruments that are in some way tied to LIBOR costs. But why did that happen? I mean, you mentioned it was an earlier benchmark, the three-month treasury. When you think about things like student loans or credit cards, it's not intuitive why the industry would start to price those off of bank lending rates as opposed to something a little more industry neutral. I think if you look at,

bank assets and liabilities, the co-evolution of that through time is part of what drove LIBOR's popularity. Again, some of the old floating rate indices that banks used to use were things like prime or CD rates. But as LIBOR kind of gained primacy in the derivatives market, in the futures market, more banks decided to adopt LIBOR as both its asset and liability indices. And when you do that, you basically set policies to, say, have a fixed floating funding mix, and the floating part of it is going to be directed towards the standard benchmark, which is LIBOR. Likewise, on the asset side, then as LIBOR kind of becomes the standard liability side, the asset side is going to take LIBOR as well as its benchmark. So again,

increasingly over time, you had more and more bank products beginning to index the floating rates off of LIBOR. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-dispos. demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations, but they usually rerun their radio newscasts throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to

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because of course the thing has not been doing much for years and years and years and we all kind of forgot about it. And then suddenly, it's in the headlines once again. Scott, walk us through, what's happening with the rise in LIBOR. Sure, Tracy. Since the end of 2017, we have seen LIBOR, especially three-month LIBOR, which is the benchmark in LIBOR space, rise more than half a percent. And this is in the absence of any Federal Reserve rate hike over that period. So that has obviously been of major concern to the market because everything is basically

indexed off of LIBOR. So to me, what I wanted to do was to us to look through strategists or analyst research to say, okay, what has been the driver of this? And I was really not able to find it. So I basically had to do my own analysis. And that really drove, you know, what we found out, which is that if you look at how much libel has risen and you really try to attribute it into different sources, what we find is that about half of the rise came from the market pricing in.

future Fed hikes, only half. So that means the other half has to come from some other sources. About two-thirds of that is coming in our analysis from increases in short-term treasury bill supply as the government is in the process of funding the tax reform. But there is a small but recognizable component of the libel rise that is due to shifts in the credit market, which identified as well. Break down that second half. So it's easy enough to understand how you could figure out how much is attributable to expectations for an increase in Fed funds. That the other parts, where you said part of it is short-term treasury supply, I guess, competing with interbank lending and also the slight change in credit perceptions of borrowers. How did you sort of disambiguate

those two aspects? Right. You can think of LIBOR as a bunch of of stacked Lego bricks. So at the bottom of that stack is the riskless rate, how much the market is expecting Fed funds rate to move. And we can find that out by looking at market predictions of three-month OIS overnight index swap, which is where market's pricing average three-month Fed funds. That's the bottom stack, and we find that that's really about 58% of the LIBOR rise. The next set of Lego bricks is really actual securities. And the... the least risky securities in the three-month sector is three-month treasury bills. So we looked at how much three-month treasury bill yields have changed since the end of the year.

We found that it rose 37 basis points. From that 37 basis points, you subtract the 24 basis points, the bottom stack of Lego bricks that's from the three-month OIS, and the residual, the 13 basis points, we attribute to increase treasury bill supply. And then the final piece of the puzzle is a difference between, three-month treasury yield and the most comparable instrument to three-month LIBOR in market, which is 90-day financial commercial paper rate. And that difference contributed to the final eight basis points of the puzzle. So this is actually the only analysis that I've seen

attempt to quantify each of those aspects and their impact on LIBOR. It's really good. But talk to us about the tax component of it, because I think for most listeners, when they think about tax reform, they're not necessarily going to start thinking about what the impact is going to be on money markets. Sure. And the impact of tax reform vis-a-vis what we're talking about today is that as tax reform was enacted, obviously the companies that had a significant chunk of their overseas earnings left in overseas markets had a break in terms of repatriation. Now, a lot of these were already invested in dollar assets, dollar short-term assets, such as a CP market. So, There was no significant asset allocation shift from that repatriation.

However, what has been noted by industry sources such as Credit Suisse is that since the passage of tax reform, the CP market has seen significant shortening of the maturity stack. So what we've seen is that the percentage of the CP market that is six weeks or shorter in Credit Suisse's research has risen from low 50s to mid-60% over that same period. Now, that may not seem very much, but it's a pretty substantial shift in terms of the sponsorship. And my interpretation of what that means is that the cash-rich companies, such as Apple, who have had that cash overseas, when they bring it back, they tend to want to keep it in shorter maturity paper because they're not necessarily sure what they're going to do with it. Perhaps they're going to be announcing some bonuses for workers. Perhaps they're going to start building another headquarters. whatever that may be, there is some policy and certainty on the part of the company.

And as a result, that's reflected in the stance of their Treasury Department who are managing this cash flow. Their stance would be, let's keep it shorter until we figure out what to do with it. If we're spending it, great, we don't have to do very much with it. So the shortening in the maturity profile in the CP market has really been the big driver of this increased credit component of LIBOR. So is this worrisome? The numbers don't seem very big, and we're certainly not talking about anywhere near the scale we saw during the crisis or anything like that. But how much anxiety should the increase, particularly in the credit component, cause people? For now it is not worrisome. If you, again, if you sum up the treasury bill component and the credit component that adds up to roughly about 25 basis points or roughly one fed hike. So it's not that worryome. some right now, maybe to the majority of the world, but to the Fed, that is an issue that they need to keep an eye on, because if that component of LIBOR continues to rise, then it has the impact

of additional unintended Fed hikes that will reduce liquidity in the marketplace over and beyond what the Fed is doing. Well, I was going to ask, the consensus is that we shouldn't all freak out just yet, but what is the say about the Fed's exit from monetary policy? At the very least, it seems like it's a good example of how tricky it might be to actually tighten monetary policy and the number of things that the central bank is going to have to take into account, you know, like fiscal stuff, such as tax reform. It seems like you're asking a lot of them. Yes, right. That's absolutely right. And what we are seeing with what is going on in the CP market is that as the Fed is withdrawing

its unprecedented liquidity, any additional shifts in liquidity provision is probably going to have an amplified effect in this environment. So it's revenge of the LIBOR, but we shouldn't all panic just yet. Scott, you mentioned earlier about attempts to find a replacement for LIBOR and maybe sort of going back to the future and looking at what we used to use. What is up for discussion and what do you think the best reference rate would actually be? Sure. Currently, the government has put forth an overnight rate called SOFR, SOFR, which represents basically an aggregate where securitized borrowing takes place. So typically if you hold treasury bonds, you can pledge those bonds and borrow cash

against that. That's basically what this rate will reflect. Now, this is a very different rate in its nature from LIBOR. Libre is supposed to represent a couple of things. One is unsecurized landing and second thing is obviously for longer than overnight rates. So this proposal is really a very, very different animal than LIBOR. It is not meant to replace LIBOR. It cannot replace LIBOR because to attempt to do so would invite many, many different lawsuits on the part of at least half the market who would be disadvantaged by this. Now, the issues I have with using rates like SOFER are multiple. One is, again, you're using a securitized rate to replace, or quote unquote, replace an unsecurized rate. And second is that the reason they've only

proposed this overnight rate is because of the lack of volume in longer term rates. If you look at sort of overnight repos, hundreds of billions trade. But once you push term repo to one month or three months, the percentage of the entire repo transaction that occurs in the one month and three month point relative to the overnight point drops to well less than 10%. So you can't, this is why the government can't tell the market, hey, why don't we use the one month to prioritize rate? Because the volumes there are just not there, just like the arguments for pushing out LIBOR. There are arguments for not using LIBORs

that there's insufficient volume there. Well, there's insufficient volume in terms securitized financing as well. So the current best pick by the government is this overnight securitized rate, which I disagree with. I'm much more in favor of using a rate such as three-month T bill

because, one, it's been out there for a long time. People know what it is. Two, it's weekly auctioned treasury bills. The rate determination is based on a very transparent auction process. And if we need daily sets, we can certainly increase the frequency of these auctions and still get significant volume. For example, the previous weekly three-month or 13-week Treasury bill produced well over three times the 50 billion of Treasury bills that was sold. So there's plenty of liquidity in the Treasury bill market. And I think the government in putting all of its weight behind so far is really doing the wrong thing.

And by doing the wrong thing, I mean that we didn't come up with LIBOR as the benchmark rate by Fiat. The market kind of gravitated towards that. There was more and more usage. It started off with Treasury Bills. Market usage kind of gravitated around LIBOR as a benchmark. And so I think creating a benchmark by Fiat is something that is going to have difficulty working. I think what the government and others should do is to promote a variety of different types of floating rate indices. and kind of let the market decide.

Now, it's harder for the market to decide right now in this market environment, because in the past, derivative instruments are pretty much traded over the counter, so it's just, there's no regulation, it's just bilateral agreements. Now, pretty much all the swaps that are done have to be cleared. So to really have a new benchmark going,

one needs the cooperation of regulators, like the Fed, of the OTC clearinghouses like CME or LCH, and also entities such as FASB, because FASB issues regulations governing hedge accounting, for example. So corporate relations aren't going to use a new floating rate index if FASB doesn't sub-bless this rate. So it's harder, I think, for people to come around a new benchmark, but I think we do need to let the market decide what the appropriate benchmark is rather than just being told that you have to use SOFAR going forward. But another interesting stat I had, as I pulled derivative counterparties, is that even now, many, many years after the LIBOR crisis, well over 90% of all the swaps that's traded in a single day is based in LIBOR.

So that really tells you sort of the staying power of LIBOR, which goes back to my statement that, you know, the rumors of his death are greatly exaggerated. Well, I was just going to say, you know, let's say, okay, the government or regulators settle on some new benchmark, how difficult in wrenching of a process would it be, given the number of instruments that are currently based on LIBOR to say, okay, everybody switch? Well, I think it's going to be a long time coming. The Fed only started publishing SOFER, well, only will start publishing SOFER in April. Market's going to have to get its arms around how this index looks versus other indices that are familiar with.

Fed funds in terms of overnight comparison. It's going to have to be a basis swap market that develops around this index. And then over time, people may start trading this index outright in futures form, in derivatives form, in swap form. So it has to be a block by block process. I think the timetable that regulators have put forth, i.e. Libor is going to be basically outdated, outmoded, eliminated by 2020, 2021. I think that's pretty done and very. vicious. Okay. That may be the spookiest part of this entire story. Scott Peng, CEO of Advocate Capital Management. Thank you so much. Thank you very much, guys. I appreciate it. That was great. So, Joe, I love that conversation because as ever, it sort of brings back the good old days of

financial crisis history for me. What a time to be a markets reporter. Well, I think that was a great conversation because A, it was right in your wheelhouse and you've covered this a lot. and you understand this stuff better than most people I know. And B, I don't really understand any of this stuff. And I've always been sort of a little shy around this topic. So it's kind of the perfect conversation for both of our needs, your expertise in me, this big hole in my knowledge that I really needed to fill. Now, Joe, I'm sure that's not true.

I'm sure you understand it very well. But I think if anyone wants a broad takeaway from this conversation, it's that there's this thing called LIBOR that exists. and it's incredibly important for the financial system. It's incredibly important for our system of credit. And it's the thing that trillions, literally trillions of dollars' worth of assets are actually pegged to. And no one really knows how it works or what affects it.

Like we are here having this discussion. We've been talking for about, let's say, 25 minutes. And we can kind of figure out some of the things that might be causing it. But there's no exact certitude. And in fact, if you talk to other analysts in the market, they'll have all these different opinions. That kind of amazes me. Yeah, I know. There's been all these stories we've done and seen recently about this inexorable rise in LIBOR and everyone has their own theories.

So the degree of non-consensus about what's driving it has really been fascinating. I'm also just really interested in the point that Scott made about the sort of organic natural way that LIBOR emerges. It wasn't by fiat. It wasn't saying, okay, we're going to price all this stuff towards LIBOR. It is a sort of network effects thing where more and more entities thought it made sense. And the sort of difficulty of replicating that process in an artificial manner and just saying, okay, now we're doing something else, very different from the environment through which LIBOR originally emerged. Yeah, it's going to be really interesting to watch and see how long it actually takes to come up with the replacement and then transition it in. Yes. All right. This has been another episode of Oddlots. You can follow me on Twitter at Tracy Alloway.

And you can follow me on Twitter at the stalwart. And you should follow our producer, Tofer Forges, at Forges T, as well as the Bloomberg head of podcast, Francesca Levy, at Francesca today. Thanks for listening. On April 4th, 2023, around 2 in the morning, a man was found stabbed multiple times on a science. in downtown San Francisco. Hey, who did this to you?

What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16.