Odd Lots - This Is What Happened To LIBOR During The COVID Crisis

Episode Date: June 5, 2020

Welcome to Part V of the Odd Lots LIBOR series, in which Tracy Alloway and Joe Weisenthal take a look at life after LIBOR, the interest rate tied to more than $350 trillion worth of financial assets.For our final episode in our series on LIBOR, we look at what this particular crisis has meant for LIBOR and the transition process. We speak with Josh Younger, a managing director at JPMorgan, who looks at what LIBOR itself did during the worst of the market stress. He also identified specific ways that the market volatility may impede some of the target dates for moving off the benchmark index.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 episode of the All Thoughts podcast. I'm Tracy Allaway. And I'm Joe Weizenthal. So Joe, I know I said our LIBOR series was at an end, but as we discussed in the previous episode, I lied, and I sort of lied twice because we have two extra episodes, and this is the second one, although I promise this is actually the last one. Who knows? Maybe this won't be the last one.

What can I say? Libor gets people fired up and everyone really wants to talk about it. But I will say some of the episodes that were early in our series, we actually recorded those before we had the big March sell off and all the volatility that we saw in the market. So I think we should actually have another discussion about what we've seen this year with the coronavirus crisis and what it might mean for the LIBOR transition. Yeah, no, I agree. I do think it's good to talk big picture and the sort of long-term trajectory of what's coming for LIBOR and the replacement. But in the meantime, LIBOR still exists. And so talking about how this benchmark, you know, what's happened with it during those extraordinary several weeks and months for the market is sort of a useful thing as well, I hope. Yeah. And I guess the big tension that sort of emerges is should. we be attempting to do this big redesign of the financial system, basically redesigning the reference rate to which trillions of dollars of assets are tied at a time when we're distracted

by so much else going on in finance, right? We're in the middle of a financial or maybe not financial, but an economic crisis. The Federal Reserve is rolling out all these new programs. Regulators are, you know, looking at financial stability, things like that. Should we be tackling LIBOR at this exact moment. So we're going to explore that tension in this discussion. And we have a guest today who's a fan favorite for sure. People have, we've had him on before, and he had been requested a lot. And then even again, I've got requests like, oh, you should talk to him again. So everything is aligning for this episode, or the culmination of the series. The interest rate stars have aligned for us. All right, well, without further ado, let's bring on

Josh Younger, head of U.S. interest rate derivative strategy over at JPMorgan. And as you mentioned, Joe, a previous oddlots guest who talked a lot about some of the turmoil that we saw in the treasury market in March. Josh, it's great to have you back on. Yeah, it's great to be back. Thanks for having me. So maybe just to begin with, you could give us a sort of summary of what happened to LIBOR in March when we had the market volatility and not just market volatility, but we did start to see the beginnings of some concerns about the banking system, and that sort of reflected in the interbank lending rate. So what did we see? So I think it's best to go back to 2008, and that was an environment where LIBOR was this really important kind of canary in the coal mine

for bank funding stress and ultimately the stability of financial institutions. So when LIBOR started it to move and other short-term rates like Fed policy expectations did not, and that spread, that difference widened out, it ended up being a really important forward-looking indicator for the problems that were going to come and ultimately led to bailouts and a couple of near-or-actual bankruptcies and all of the problems that the financial system was facing were kind of pre-presaged by moves in LIBOR. So that's been something people have watched for a while, and there have been episodes over the past 12 years where LIBOR was once again in the spotlight, and the best example of that was the European sovereign funding stress episodes of 2011 and 12. When initially

Greece and ultimately Italy and Spain were coming under stress, their banks were either directly or implicitly part of the LIBOR panel. And we can talk about that as well. But the banks in Europe were all interconnected to some extent. And problems in Italy and Italian banks were ultimately problems for German and French banks. And that went into the LIBOR fixing. And LIBOR OIS being Fed funds, you know, Fed policy expectations, the difference between those two rates widened out quite a bit. So that was ultimately like something people watched is this financial stability, financial conditions indicator.

More recently, we saw an even larger widening in the. in LIBOR versus OIS back in March. And so that was really the largest move in that spread since 2008, and there was immediately questions as to whether this was another, you know, canary in the coal mine, meaning, you know, Libre OIS is widening up. Does that mean, as much as the banks are telling us that everything's fine and we're better capitalized and we're more stable? And we have all this high-quality liquid asset stock to rely upon to raise liquidity,

like, are we actually in trouble? and the market knows about it, but maybe the public doesn't yet. And that's priced into LIBOR. So this was one of the two or three things that was really closely watched by a variety of people and ultimately the public because problems with banks or problems for the economy, especially in a major economic shock at the same time. So then all the questions really surrounded what was actually driving. this move in LIBOR. Was LIBOR telling us something about the banking system? Or was LIBOR telling us

something about the way that we construct LIBOR now that's much more technical and frankly, less interesting to the broader public? And it turned out to be mostly the latter. So explain that further. I mean, actually, when we talked to you last time, which may have actually been at the very end of March or maybe early April, we still were right in the thick of the volatility. but a lot of that conversation was about what was going on, not with the banks per se, but with other entities that were trading treasuries and trading futures and the illiquidity in that space. So from your perspective, what was LIBOR?

What was that widening really telling us and what did it have to do with the volatility at the time? Yeah. So ultimately the question is, what are we really seeing when we see a LIBOR fixing? Let's say today LIBOR is 35 basis points. What is that number? What goes into that number? In the pre-crisis days where there was a lot of interbank trading of short-term lending and so forth,

like LIBOR had actual transactions behind it because banks would do those short-term loans relative to each other. But somewhat tongue-in-cheek, we say these days there's no I in LIBOR. The I stands for interbank and there's no interbank trading where there's no significant interbank trading. And so the Intercontinental Exchange is the benchmark administrator. They put out a couple of years ago revised guidance for panelists as to how they submit their quotes. So to quickly review, you know, LIBOR is this panel of banks, large international banks that are active in short-term markets. Every day they're asked where they think they can borrow and they're supposed to put in a number and you don't have the option to just, you know, pass. So you have to put a number in every day.

it's easy to put in a number if you paid borrowed money that day. And that was very frequently the case in the sort of 2000-200-20-period, and even earlier than that, the problem is now because there's not much interbank lending and borrowing, they're forced to rely on the commercial paper market. So the question is, did I issue commercial paper or a certificate of deposit today? And if I did, then I've got a really great way to make my quote because I borrowed money today. let's say I borrowed at 40 basis points.

So I tell the ice that I borrowed at 40 basis points. But when we look back over the past year or so, on average of the 16 panelists, only say four or five on average are doing that on a given day. So what do I do if I don't have a transaction to point to? And the ice released what they call the waterfall, basically a prioritized list of other things you can look at. to come up with a number that's supposed to be like close to where you could borrow, but you're inferring it, you're not actually observing.

So one of the interesting things that happened to LIBOR in March was it hit a pretty sharp peak. I think it was something like, I want to say 1.4 or 1.5%. And then it took quite a long time to sort of start coming down, even though the Federal Reserve was unveiling all these new programs to inject liquidity into the economy. The technical dynamics that you're describing, is that something that would, I guess, prevent central bank stimulus measures or monetary easing from impacting the LIBOR rate as well? Yeah, there's definitely a policy transmission issue. So when the Fed moves interest rates around, they're ultimately trying to stimulate the economy

through the cost of loans. The problem is they target the federal funds rate, and there's not a ton of loans tied to the federal funds rate. So when the Fed moves interest rates, they rely on the relationship between that federal funds rates and other interest rates to actually sort of get the stimulus into the real economy. And as I'm sure your other guests spoke about, the LIBOR is by far the most pervasive of those interest rates. So to some extent, if it doesn't get passed through LIBOR, then it doesn't have nearly the same effect. And when the Fed cut rates 100 basis points, LIBOR didn't really move in March. And so you didn't really have a ton of stimulus, at least immediately, into the economy.

There's also the question of whether interest rates were really the thing that was causing issues, which I think is a different conversation for somebody with more economics training than me. But if we say the Fed's trying to do what they can, lowering interest rates is the most straightforward and classic thing they can do, if that's not passed through the LIBOR because of these technical issues, you've got a problem. And so, you know, I was kind of alluding to earlier is that there weren't a lot of transactions. And when we talked in April, you know, one of the issues was that the capital markets essentially shut down. So what was typically four or five panelists

issuing commercial paper on a given day, which is, again, pretty small fraction of total number of panelists, that number went to like two or three when LIBOR was rising. So, the rise in LIBOR to a large extent reflected other kinds of funding stress that are not really tied to like bank credit. So this wasn't really about the ability of banks to repay loans because of the risk of bankruptcy or failure. It was about the cost of securing dollars through other sources and just the scarcity of dollar funding in general, which is a very different thing. And frankly, much less concerning for overall financial stability because if bank credit is in question, And that has all kinds of knock-on consequences for the economy, which we learned about in 2008, 2009. Well, so, okay, so in March, the rise in LIBOR didn't necessarily reflect what was going on with bank credit, which is good.

But in terms of its function as a benchmark for all kinds of loans and derivatives and other instruments, was it still basically serving its purpose if it was a measure of overall funding conditions or funding stress elsewhere? in the financial system, that doesn't necessarily strike me as a bad measure to still use if we're going for LIBOR's main purpose. So I guess when we think about LIBOR, like, what is it supposed to do? Like, why did we make an index out of bank borrowing in the first place? Because we could have just tied everything to Fed funds. Right. Or the prime rate.

Like, we have the prime rate. That's an alternative. And when we initially constructed LIBOR, the idea was, you know, I need some kind of credit components. So using Fed funds or the prime rate is not a great measure because like this is a benchmark against which loans to individuals and corporations is going to measured. So I want some elements of underlying credit risk in this index. So who's the best credit around? Arguably it's it's the largest international banks. So the question is if I want to borrow money, I, Josh, want to take out an adjustable rate mortgage, my credit is 275 basis points worse than a good bank.

And so I have this like benchmark that's tied to ultimately, you know, private market, you know, credit exposed institution, but one that's kind of high up on the, on the scale of qualities of credit. So when you have LIBOR moving because of broader funding market conditions, and that really means the ability to find those lendable dollars, It's a very technical thing, right? I mean, if you're unconcerned about getting your money back, but you just don't have the dollars to lend because they're locked up somewhere else, so you can't pass them through the pipes effectively,

like, is that really the benchmark we want to use for adjustable rate mortgages, for corporate debt, for corporate loans, for the Main Street lending facility? And so the question is, is not whether or not these disruptions happen because, you know, any imperfect measure is going to have issues occasionally, the question is, is this something I can expect to persist over long periods of time? Is it going to lead to a lot of volatility in interest rates that's not really reflective of the credit markets? And so am I sort of creating more trouble than it's worth in tying the lending market or continuing to tie it to this bank credit index that's constructed in this imperfect way? I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal story. that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets,

from corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. So I think you actually coined the term zombie LIBOR, I think you were writing about that possibility back in September. When you look at what was

happening in March where, you know, you didn't have a lot of these lending transactions on which to actually base LIBOR. Do you think the risk of ending up with zombie LIBOR, as you put it, is increased or that there's proof that we're sort of heading in that direction? Well, the zombie LIBOR outcome, and just to review, I mean, that's a scenario in which you have this panel of 16 banks. And starting in 2022, the beginning of 2022, the regulators are going to allow banks to drop off the panel. They're no longer going to compel membership. Because at the moment, if you want to get off the LIBOR panel, it's actually not so easy to do.

And they're doing that because they need a decent number of banks to get a decent sample in that index. And so when people talk about LIBORs, quote, unquote, going away in 2020, at the end of 2021, early 2022, what they're referencing is the FCA, the Financial Conduct Authority's statement that, they will no longer compel membership. And so the presumption is, if you don't have to stay in that club to which you would not like to join or remain, you'll leave. And there's lots of reasons why one would want to leave that particular panel. And so zombie larbour is a scenario where a lot of banks leave, but not everybody does. And you're left with a kind of small contingent of, say, five or six submitters.

And that leads to a lot of volatility because if you pick the wrong set of five, you could end up with a much more volatile index. Thankfully, there's kind of a regulatory solution to this. So if the FCA and the benchmark administrator coordinate to some extent, they can come up with a scenario where the FCA deems LIBOR to be non-representative. And instead of continuing to post-fixings, because the ICE, the benchmark administrator,

they're under no obligation to keep posting LIBOR or to stop posting LIBOR, but the FCA can simply say they don't think it's representative, but you can keep producing fixings. They have come together and said, look, we're not going to do that. If the FCA says LIBOR has entered a stage where it just is no longer representative of credit markets, then we, the benchmark administrator, will stop publishing it pretty soon thereafter. So I'm sort of less concerned about that at the moment because of that coordination. And that's a good thing because, like, all.

of the rules, and we'll probably talk about fallbacks and all these other things, like, if LIBOR is still getting produced, unless you specifically account for that scenario, you could end up in a situation where you keep having to reference a rate that is increasingly problematic. And LIBOR has its problems now, but there's 16 contributors. Imagine they were five or six, and all problems would be magnified. So, just while we're talking about the events of the last couple months, I mean, one of the things is this series is gone. on. We've talked about the various steps, the difficulty in transition. Of course, we want to get your broader perspective on that. But have there been any substantive ways in which what we've seen since the beginning of this crisis has changed the planning and overall trajectory? So it hasn't changed the planning. The question is how we, I think it comes back to the question of like, how are we actually going to do this thing? Meaning we can say we want to get off of LIBOR. We can threaten to get rid of LIBOR, but unless all the pieces are in place,

that's a pretty risky proposition because you're now talking about ripping out one of the central elements of the financial system in a pretty rapid fashion. I mean, 2022 is not that far way. And so you've really got to make sure that you've kind of ring-fence the potential risks around doing that because I think we can all agree, like under normal circumstances, you don't want to destabilize the vast majority of the lending and derivatives markets, and you definitely don't want to do that now. So what about March has made that either more or less likely, getting those pieces in place to actually get to the point where we can say we're off of LIBOR and specifically stop publishing it? Because if you were to do that now, you'd have a lot of problems. So the first thing

you've got to do is you've got to come up with fallback language that takes care of the fact that when most of the existing loans and derivatives were written, they didn't really contemplate a permanent end to LIBOR. So my favorite example of this is in some notes that are floating interest rate, which is supposed to observe LIBOR every quarter, they say, well, if there's no LIBOR today, look at the last valid LIBOR fixing you can find and use that to calculate the payment, which makes total sense if you think it's a day or two, but not if it's going away forever. So if you own a security that's supposed to pay you whatever LIBOR is now and LIBOR goes away, you're taking the risk that LIBOR goes away at a very low interest rate level.

You just don't know. We don't know what LIBOR is going to be in the future. And so that's rolling the dice in a way that's not particularly appealing. And if you go to the derivatives market, which one of your other guests might have mentioned scales and stuff like that, but $200 trillion is a lot of money. and those payments are benchmarked to LIBOR. And the way those fallbacks were initially set up was they said, well, if LIBOR is not there today,

then pick up the phone and call people and try to get them to quote you a level on a more informal basis. And I think it's fair to say that if banks don't want to be in the LIBOR panel, for variety of reasons, including liability and so forth, they definitely don't want to be picking up the phone and just quoting something in an informal way. So in the case where you can't actually source informal quotes, then you're kind of at a dead end, which means there is no number with which to calculate the coupon payments on $200 trillion

of notional worth of derivatives contracts, which, you know, if you were a lawyer, that would be a great setup. But for the rest of us, like, that's not a great situation to begin. And so, like, the key is to amend all of these contracts, not just derivatives and loans, but also mortgages and a variety of other things to make sure they have, you know, clauses that take care of this eventuality. And so that's the ISDA fallback protocol process. It sort of serves two purposes. Isda being the derivatives industry organization is putting forward standard language

for all derivative contracts take care of this. And what they're doing is they're using a historical observation of LIBOR versus SOFER, the secured overnight financing rate, the replacement for LIBOR. So look at the difference between those two things, look at its historical average, and now what you thought was going to be LIBOR is now, you know, SOFER plus this spread that we're going to observe over the past five years, let's say. So that's great for the derivatives market, and they're close to putting out, you know, the triggering terms,

like under what circumstances do you do this, specifically, how do you actually calculate this spread, et cetera, and they're close to being done with that. And the key there is that once you have a standard language, you can incorporate it into other things. So a lot of the push has been to make sure that all of the cash products, all the securities and loans and other non-derivative instruments, basically align with whatever language ISTA comes up with,

because then you have a single industry standard. That's a good thing, just less to, to argue about. The other thing is that the hedges that are used to manage risk associated with those investments are going to have the same fallbacks. Because the last thing you want, you think about a large financial institution,

like a major commercial bank, they have hundreds of billions of dollars potentially in interest rate swaps. And those are used to fund, or at least they're associated with the funding of assets. And so even a small mismatch in the way fallbacks are triggered, that could be a very destabilizing thing as well. So you want everything, everything lined up, nice and nice and uniform and matched off across the whole range of things with libel exposure. So, so that's the first thing. That's the first step. Should I let you,

well, it does feel like the industry is basically attempting this gargantuan feat at a very, very tricky time. And we have these key deadlines coming up as well. Do you get the sense that anyone is sort of reconsidering the transition in the current environment, or are they still pushing forward to the extent that they were earlier? So there's still a lot of pressure to get it done. The UK regulator has said plan on 2022 or end of 2021. They've acknowledged the risks, but the guidance has been to sort of plan on the original schedule. The fallback stuff I was talking about, that's most. done. So I wouldn't necessarily do that as a big concern. The issue is how are we going to

jumpstart a new market in the middle of a market crisis? And so the Sofer market is new. Like, there's not that much of it out there. There's been a decent amount of issuance of securities that reference Sofer, but they're almost all from three government-sponsored issuers. There's some trading in derivatives, both on the exchange, the futures contracts, but much less. in the over-the-counter swap market. And so, like, you don't have a lot of transparency and visibility into that component that's going to become central to everything. Like, we don't have a great sense of how the market would manage risk around SOFER cash flows.

And the question, and this is the part that I think is the risk factor that you're alluding to. How do we get people to trade SOFER? Like, how do we actually push people in that direction? because, you know, this book, Nudge, which says you put in small incentives, people will tend on mass to go in one way. Financial markets don't have nudges, they have shoves. Like, we don't do small things. Incrementally, there really needs to be a strong push because familiarity and liquidity and, you know, overall risk management strategies tied to things.

It's just hard to move. And so we need some kind of lever arm to push the market from LIBOR to SOFER. And this is where there's an interesting way in which we can utilize the post-2008 crisis. I guess we have to specify the crisis now. But the post-2008 crisis regulatory regime said, we're worried about interest rate swaps between two counterparties. So we want you to all use a centralized counterparty. This is CME and LCH. This is the clearing houses.

And so the idea was have a central counterparty to which all swaps are. are eventually facing, and that means that you can make sure that entity is well capitalized and it's a ton of transparency and so, and just a much less complicated market. And the reason I'm highlighting this is that that central counterparty now has an enormous amount of influence over how the swaps market trades, because basically everybody with very few exceptions or relatively few exceptions has to do business with the centralized counterparties. There's two of them, you'll see me in LCH. So the alternative reference rate committee and others have been coordinating with them.

And it turns out there is an asset which is quite large, very actively hedged, and controlled in some sense by the decisions that these two central counterparties make. And that is the value of all U.S. dollar interest rate derivatives. So if I have a swap contract that I executed, say, a year ago, it was word zero at the beginning. This is true of all derivatives, right? They have zero value at initiation, but now let's say it's worth $5 million. So how did I come up with that number? What you do is you say, what are the terms of this contract? How do they compare to the current terms of the contract? And what is my discount factor? What is the time value of money that I should assume in calculating the present value of those cash flows? And this all sounds relatively technical. The key is that the clearing houses use a

particular interest rate to calculate the value of those swap contracts. The gross value of those swap contracts is something like one and a half trillion dollars at times. And it is very heavily influenced by the choice of that interest rate. And they can in principle change that interest rate from the effective federal funds rate, which is what it is now, to SOFER. So now I've created an asset that is very highly correlated, its value is very highly correlated to the Sofer rate. It's very large. It's, you know, a trillion dollars. And its value changes a lot because as interest rates move, the value of interest rate swaps

changes. And that means that if I was hedging changes in these valuations, I need to change my hedges. And banks do that a lot. So I've sort of created a very highly, call it convex, meaning its value change. changes as interest rates move, very highly convex, very large, very explicitly tied to sulfur asset. But now the banks are all going to have to hedge. They're going to do that with sulfur swaps.

And so all of a sudden, I've created an environment where there is a lot of trading and activity in sulfur-linked instruments. And I've jumped started the market. And the plan was to do this in October. And the clearinghouses had agreed to this. They came up with a plan for it. The problem is that plan relies in part on the willingness of the market to kind of price out, to put together expectations for what long-term sofer payments would look like versus other interest rates.

And the experience of the past two months has not been great for that kind of activity. So the risk is that in affecting this transition, in affecting the transition of the valuation of interest rate derivatives, you sort of cause significant problems because there's not enough buy-in from the counterparties you need. And that would be very disruptive if it were to happen. Can you just explain that last part, again, spelled out what the risks would be? And is there a possibility that that date in October could just, I don't know, move to early next year or something like that? Yeah. So, like, if I'm a centralized counterparty and I'm going to switch my discount factor.

Yeah. So let's say I've got 100 trades. And they're currently worth $10 million using the discount factor I currently use. And now I'm going to change to that from the effective federal fund rate to SOFER. Well, I need to know what that, not just what the sofer rate is, but what the expectation for the difference between the new discount factor and the old discount factor are going out 10, 20, even 30 years. And so the way these expectations are usually arrived at is you have a population of specialists who really do these kinds of trades. So there's a whole market in like 30-year average difference between the federal funds rate and LIBOR. Like we trade swaps like that.

And there's a population of investors who come up with those expectations for a variety of means and then gets priced into the market. And there's an observable benchmark. So if they participate in these discounting factor switches, then we can actually do it. If they don't, then you're left with a new discount factor that nobody knows. well, and the valuation of the whole swaps market becomes highly uncertain, not a great outcome, and you've sort of created more problems than you've solved. And there's a risk that there are significant losses that percolate through the system, and those who are most exposed to the small differences in valuation are going to be, you know,

participants in the market who have lots and lots and lots and lots and lots of positions that are mostly netted off, but has small residual differences, that's a dealer. Like, that's a bank because they're market making and all these things. So uncertainty is bad for this whole process. And if you try to push it over the line to quick and you don't get the buy-in from the specific participants that you need, you end up creating a lot of uncertainty. At the moment, it's sort of full steam ahead. And, you know, the thought is October is a long way away. Things look a lot better. Markets mostly stabilized at this point. I, you know, I see no reason to delay it.

I think as we get closer to the date, it will become clear if there is sufficient buy-in from the right people. But at the moment, the thought is I'd stay on schedule because if we don't do this, then we can't do the other things. And once you have people trading swaps, then let's say you were a corporate borrower in Middle America and you've got a loan that's currently live or plus 3%. And your bank calls you and says, you know, we just changed this new interest rate called SOFER. And, you know, we need to quote you a new spread. So we're going to make it SOFER plus three and a half percent. And your immediate response would be, I don't know what SOFER is. So explain that to me.

And two, how did you come up with three and a half percent? And the best way to do that is to have some derivative traded that you can point to and say, look, the market is pricing this set of expectations. So for your five-year loan, the market says the difference between LIBOR and SOFER is going to be half a percent. So it's fair for me to charge you an extra half a percent because that SOFA rate's going to be lower on average over the next five years. To do that, you need to have trading and SOFAR swaps and to have that you need the big bang. So it's all about laying up the pieces over the next six to 12 months so that ultimately we can have a loan market that's mostly, at least new loans are mostly benchmarked to SOFER. and you have that pricing transparency.

You've got participants and users of interest rate derivatives moving them to the new index. You can have the mortgage market moving to the new index for the most part. You're starting to whittle down the population of LIBOR products that you have because at the moment it's still growing. The market's overall risk to LIBOR has increased, not decreased over the past year, even as the deadline has approached. And it's because people are used to LIBOR. When we write new loans now, we typically do them versus LIBOR still.

Most of those credit facilities that have been drawn on in the crisis, most of them are linked to LIBOR. Most of the Fed program was originally going to be linked to SOFER, but they changed the LIBOR because the market's not ready for SOFER-length Main Street lending loans. So, you know, the way we, and if you have this thing where the risk you're trying to manage down keeps going up, It's not a good setup to get rid of LIBOR in two years. So unless you put these pieces together in a relatively precisely sequenced fashion and quickly, you're not going to have a situation where the market's ready to get off of LIBOR on schedule with respect to the deadlines. A lot of short daily news podcasts focus on just one story. But right now, you probably need more.

On Up First from NPR, we bring you three of the world's top headlines, every day in under 15 minutes because no one's story can capture all that's happening in this big, crazy world of ours on any given morning. Listen now to the Up First podcast from NPR. Josh, you mentioned these specialists who are very good and practiced at pricing these things out for a long time. When it comes to the, just real quickly, when it comes to the switch to Sofer, is there any more technical challenge from their perspective or is it again just sort of habit and inertia in terms of whether they'll be, you know, fully ready to do that and buying into it? I think it's a couple of things. The first is it's technical in the sense that, you know,

we need to have a sort of theory of SOFER and how it relates to other interest rates. And we have a decent sense of it over the past five to 10 years, but world's changing pretty quickly. And so when the Treasury wants to issue $5 trillion worth of collateral, it has implications for the repo market, which means there's implications for SOFER. And so, you know, what does the long-term deficit outlook look like has a lot to say about how the repo market's going to behave. You've got bank regulations that are changing, even on temporary basis. So it's hard.

That doesn't mean you can't come up with a number. The key is, if you might be wrong, you have to be in a position to wear those losses and not have a problem. And the issue is that one of the hardest hit communities, at least in the sort of institutional investor class in March was the relative value hedge fund and asset manager community. And that's precisely who you're relying on to come up with these numbers. And so there's a lot less margin for error if you've had a bad year already. And the willingness to participate in saying, it's voluntary.

Like you don't have to do this if you're a hedge fund. Like you can just choose not to participate in SOFER and that's fine. And so without that buy-in, it's just going to be hard to keep the process moving along. It doesn't mean you can't sort of accept the risk of volatility and push forward and say, look, you know, things look fine. I think they'll participate. And, you know, even if they don't, you know, the miss will be small and we'll just, you know, keep things on schedule because it's more important to stay on schedule,

given the level of risk that we perceive. That's a perfectly valid perspective. But, you know, it's not clear to me that that will obviously be the case come October. I wanted to ask you something sort of more conceptual about. Sofer. So you mentioned at the beginning of our conversation when you were talking about LIBOR, that LIBOR does have this credit component in the sense that it's basically a sort of interbank lending rate. And SOFER somewhat controversially doesn't have that credit component. How do you see that impacting the financial system and transactions? And does that mean that SOFER is inherently not a sort of

perfect match for LIBOR? It's definitely not. a perfect match. I think there's no good answer to this problem. So on the one hand, LIBOR has credit exposure, which sort of is perceived to be beneficial in certain ways. But it kind of depends on who you are in that equation. You know, LIBOR tends to go up when the market, when interest rates go down. That's just, you know, interest rates go down when the economy is worse. And that means credit, the credit outlook is worse. And so LIBOR should go up relative to other interest rates. That works well if you're the lender, but not the borrow. So it sort of depends on your perspective.

The other component of that is it's sort of perceived to be a good match to the other kinds of ways in which banks borrow. And that's another thing that's arguably debatable, but it's been put forward. The problem with LIBOR is that credit markets tend not to be very active in a crisis, which is precisely when you need the index to be its most robust. And so that's what we were looking at in March, which is at precisely the time when, Fed policy needed to be passed through to the real economy through LIBOR. The rate of transactions was dropping significantly, like markets were seizing up. The only market that was much more active, or one of the markets that was much more active,

was the repo market. So, you know, the transactions that could in principle go into LIBOR in March were much fewer, and the transactions which went into SOFER were much greater. Like the repo market got more active. So the advantage of this non-credit link, this secure lending, market, so to speak, that SOFA represents is that it is more active in a crisis, more robust in the crisis than in normal times. Well, this raises question to me, and I think we talked about it on one of the earlier episodes. Why couldn't the new benchmark just have been something,

a direct policy rate? I mean, if you're getting rid of the credit component, why not do, you know, one month or three month or overnight rates from the Fed, if that's essentially what it's going to track? So the federal funds rate is actually not a direct policy rate. So the federal funds rate is determined by the market. In the pre-crisis days when the balance sheet was small, basically the Fed would be the buyer and seller of reserves because federal funds rate is the cost of borrowing reserves on an overnight basis. So I'm borrowing cash from another bank. And I'm specifically borrowing like reserves at the Fed. And in the pre-crisis days, like, like the Fed would sort of be the end borrower and lender to maintain a rate that was like pretty consistent with their target. As the Bounchy grew in the wake of the crisis in 2008, they bought a ton of treasuries, a ton of mortgages, agency to ventures. So the Bounci got a lot bigger, which meant there was a ton of cash in the market.

And that meant that nobody really needed to borrow cash because you would typically borrow cash to make sure that you were at your minimum reserve levels for regulatory purposes. Like I need to hold institution A needs 50 billion dollars worth of reserves institution B needs 60 billion dollars where the reserves don't earn interest in that pre-crisis environment. And so I want to hold as little as possible and stays close to my minimums as possible. Now the Fed has done two things. They've increased the supply enormously and they pay interest. So if you're a bank and you have cash at the Fed, you get a positive interest rate on that cash.

So you actually are perfectly fine holding reserves for the most part. at the Fed, you don't want to minimize your exposure. And the correlate to that is who would actually lend reserves when they're earning interest on them at a rate that might be below the interest they'd earned by holding them overnight. And it turns out that the way that the regulations were changed, the way the law was changed to allow the Fed to pay interest on reserves, did not include non-depository institutions. So who's a non-depository institution?

The federal home loan banking system is technically not a depository institution. And so what that meant is that they don't earn interest on their reserves, but they are part of the Federal Reserve system. So they lend out their cash at a rate below the interest on excess reserves, and the borrowers of that cash are sort of borrowing below the interest on excess reserves rate and earning the spread between the two or possibly doing it for other sort of more technical reasons. And so it turns out that the Federal Reserve policy rate or the target policy rate, the effective federal funds rate, represents at best on a typical day, $75 to $100 billion worth of transactions, which is better than LIBOR, I should add, but not a lot in the context of the whole system, whereas SOFA represents more than a trillion dollars in underlying transactions, many, many thousands. And most importantly, the effective federal funds rate is a pretty idiosyncratic thing because it really reflects where the home loan banking system is willing to lend out cash relative to other short-term investments to foreign banks, which doesn't strike me as the index you really want to link the rest of the economy to because it's a pretty technical, pretty idiosyncratic thing.

And so Sipha represents a true market in the sense that there's many, many transactions. There are lots of borrowers and lenders, and it's a real price discovery process that's not sort of highly, highly sensitive to the minutia of things like, you know, Homeland Bank liquidity management. So it's a much more attractive rate. And the ARC sort of considered both when they are the alternative reference rate committee, they considered both and came to the conclusion that this repo rate, for all its problems, was a much more desirable benchmark than things like Fed funds.

So putting it all together and considering what we just experienced in March and April with LIBOR and SOVER to some extent. Are you optimistic that we're going to meet the deadlines for the LIBOR transition? And I guess secondly, are you optimistic that that transition is going to be done in a way that's good for the financial system and that the ultimate outcome is going to be that the industry is in a better place than it was in the LIBOR days? Yeah, so optimism is an interesting way to characterize it. I am convinced we'll get there. Is it going to be the beginning of 2022, first quarter, second quarter, second half?

I think there's a real risk that it gets pushed back just because when it comes down to it, the way you get the market off of LIBOR is you stop publishing LIBOR and hope that you covered all your bases. And there's always going to be a moment where you bite your lip and go, I think it'll be fine. We did a ton of work. We really looked into everything, but like you never really know until you, you do it. So what do I think I might have gotten wrong? And ultimately, if there's any concern about financial stability, you know, this deadline, it's good to have a deadline. It's good to work towards a deadline. This deadline was not chosen for any reason other than we need a deadline that's

realistic. So if financial stability is truly at risk, I think turning off the lights and walking out of the LIBOR room wherever it is, like, it's probably not a great idea. Whether or not that point will come, the point of confidence that we can take this risk comes on time, quote, unquote, as in the first part of 2022 or six to 12 months later, is very hard to say in advance. I think it really depends on how the next three to six months go, and especially that discounting switch, people call it the Big Bang discounting switch. That's kind of the next big event in that market. But, you know, I'm optimistic that it will happen.

I'm optimistic that it'll happen over a timeline that's not super long. And we're not talking about 20 years here. At the end of the day, if it ends up happening in the second half of 2022 or the first half of 2023, like, is that a complete disaster for the market? No, we've been working on this longer than we were working on the moon landing. So what's an extra six months? So, you know, I think that gives us a little flexibility, which is not a bad thing. In some sense, there's a value to add.

acting as if the deadline is fixed because if it gets pushed back but you're ready at the end of 21, you got no problems. If you're not ready, then you've got a big problem. So, you know, I think the market will keep pushing towards these deadlines. Is it better for the financialist system overall? You know, I think a more robust benchmark is always a better thing. And in particular, one that's tied to transactions because ultimately markets are about confidence and transparency. And so when we think about benchmarks that are embedded in basically everything the market touches, that it really get wound into the guts and the sort of ether of the financial system, it's really important that they be something that we can count on for a long time. And something like SOFER

has a lot of features that are attractive. And the most important being that it has many transactions, very hard to manipulate. I'm not sure when your prior guest talked about the manipulation scandal. It's really hard to manipulate something without underlying transactions. It's a lot easier to do it when there are 16 panelists. And it's a market with many participants, not just banks. So it's a broad mix. You know, secure lending is only getting more important because there's plenty of treasuries around. And I don't think that's going to change anytime soon either. So, you know, all of that's a good thing. As long as the process, and the arc has put forward a very clear and very reasonable and very thoughtful and careful and careful plan to push

this forward. I think at the end of the day, it's kind of like every new piece of significant legislation, like everyone leaves equally unhappy. And so library transition will leave many people equally unhappy. but financial stability and confidence is key, and I think they're heading in that direction. Josh, that was a really great conversation as always, and it was lovely to have you back on. And I'm so glad that you were the last person to sort of crown our overarching Live Boy series. So thanks for being last, but definitely not least. Yeah, totally. I'm glad it worked out. And I tried to keep it not too technical.

I hope that worked. I think it was just perfect right on the edge of sophistication, but I actually, I think I understand, I understood almost all of it. So I thought that was great. Thanks, Josh. Okay, so I think we're done. I'm sort of scared to say that. I think we are done with the LIBOR series.

Yeah, Josh, I think we're done for now. I mean, I do think, you know, it's not, the topic isn't going away, but that was a really good summary. Josh is just so clear and his ability to take a really sophisticated topic, very detailed. I mean, when I try to read on this topic, it's always difficult. But I think he's one of the sort of clearest articulator. So good way, good way, good place to stop. Yeah, he definitely has a way of bringing all these sort of various threads in the financial system together. Yeah.

In a coherent way. So I guess, I don't know about you, but the overarching, takeaway is how difficult it is to sort of retool the underpinnings of the financial system, and especially to try to do that at a moment like this. And of course, when everyone embarked on the LIBOR transition, it was right after the 2008 crisis. And I'm sure most people were hoping that we weren't going to get another crisis for some time. And yet, you know, here we are. And we're basically trying to end the process in the midst of the biggest economic recession that we've seen for many years. Yeah, absolutely. It was just yesterday's episode, so to speak. We were talking

about that moment with the clearinghouses coming up in October, and it's like, okay, this is when they're going to switch over to this new benchmark. But hearing Josh talk about why even that is going to be a challenge and how you need to get the buy-in of people who are experts at pricing this stuff, that really is sort of illuminating about illuminating. example of how just even one step is extremely complicated. And of course, there are numerous other steps involved. Yeah. And I love that anecdote from Josh as well about, you know, language in the contracts that talks about, well, if there is no available LIBOR, right? You just go back to the previous one. And most people were expecting that to be, you know, a day or two

previously. But if you actually sunset LIBOR, then you could be going back years and years and years and it's all stuff that people never really considered they would have to do. Yeah. No, it was really great. And maybe we should do another LIBOR series, but like in a year or six months or something, and then we'll see how it goes. We need to title this, the never-ending LIBOR series. That should be the name.

I like it. Okay. All right. Well, this has been another episode of the Oddlots podcast. I'm Tracy Allaway. you can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallwart.

Definitely be sure to follow our producer, Laura Carlson, who had to book and edit all of these podcasts, all of the series to get them out in a single week. She's at Laura M. Carlson. Follow the Bloomberg head of podcasts on Twitter, Francesca Levy, at Francesca Today, as well as all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.