Fixing LIBOR

The recent scandal with Barclays (which, rumours suggest, may soon spread) rigging their LIBOR submissions to enrich themselves and mislead investors, according to the FSA, has exposed some rather strange features of the system.

By far the biggest use of LIBOR is to set the value of EuroDollar (US dollars held outside the US) futures traded on CME. Each of these ED futures contracts represent the interest on a notional $1m loan for three months, and over 1.5m such contracts are traded every day - $400 trillion of notional lending per year.

The settlement price of a ED future is determined from the LIBOR fixing on the second business day before the third Wednesday of the delivery month, which means that they are equal to LIBOR at settlement, and very close (and converging) before that.

So why fix ED prices on LIBOR rather than the other way around?

Here we have an extremely liquid market, of synthetic loans with zero counterparty risk, which is arguably the definitive price of borrowing money. Why are we not using the well-honed pricing mechanism of that market?

During the financial crisis, Barclays reduced its LIBOR submissions from the actual rate at which it was borrowing (paras 12-14, 102-145 in the FSA report) to avoid media speculation about its financial position. On the other hand, the ED futures market is independent of the creditworthiness of the LIBOR submitters as the loans are never disbursed, only the interest which would be paid if they were, so this source of stress is simply not present. In a credit crunch, lenders (ED buyers) will back off, forcing sellers (borrowers) to lower prices (increase rates, and pay more interest), but not in a way related to the creditworthiness of a particular counterparty, only to the market in general.

Is this not exactly what we want to see in a published interest rate figure?

The ED futures price is determined by a liquid market, independent of the creditworthiness of any particular bank, and provides a yield curve in quarterly increments out to 10 years. Surely this is what we should be using instead of having a small panel of bank representatives "exercise their subjective judgement" to determine "rates at which money may be available in the interbank market" (FSA report, para 30)?

The market is already there, we're just not using it for historical reasons. This scandal has shown that, as ever and always, concentrating power in the hands of a few individuals leads inexorably to corruption. Let the sunlight in, and determine LIBOR from EuroDollar futures prices - not the other way around.

- KoW

Guido uncovers Anglo-Irish Bank fraud?

Guido has a very interesting story about the recently-bailed-out Irish bank seemingly providing fraudulent marks to its (less-savvy) customers.

The two circled figures for 3-month yields in the accompanying image, the actual DIBOR at 6.22000% and the figure claimed by the bank of 6.5000%, are supposed to be the same by definition.

Like mortgages, money market transactions have interest rates based on an official index (LIBOR, DIBOR, the Bank of England Base Rate) added to a spread agreed between the parties, which covers the risk to and the profit for the bank. The bank will borrow at the index rate and lend at a slightly higher one, which is perfectly sound business. Just like someone with great credit and a lot of equity will only pay a small amount more than the base rate on their mortgage, so a good corporate customer will get a tighter spread; a new or less-creditworthy customer will have to pay more to borrow.

The problem in this case is that, according to those figures, Anglo-Irish has simply lied about the index rates in order to cream off a bit more from borrowers. This is equivalent to your mortgage provider claiming that the Bank of England base rate is 1.5%, when it's really 0.5%, and therefore your mortgage is an extra £250 per month - that extra £250 doesn't pay down your debt any faster, nor is it a cost to the bank. They're still borrowing at the index rate, so the extra is pure profit without having to worry about pesky contractual obligations - you'd agreed how much you'd pay them, and they're taking more without authorisation or legal authority. Fraud, basically.

The article suggests that this was only done for less aware customers - a professional would likely have other sources of DIBOR marks and would spot the difference, but a naive customer might just accept the bank's numbers without asking, and that might double the desk's profits - if you're getting 28 basis points (1% of 1%) from lying about the index and offering a spread of 25bp, then more than half of the total profit is from the fraud. Now, if the market was uncertain, borrowers might happily pay a 53bp spread - but charging them that while telling them that it's 25bp is surely illegal.

It'll be interesting to see how that one plays out...

- KoW

What a hung parliament really means

Today's Metro (p5) has an article titled 'Hung vote' polls spark pound panic - which is only slightly different to the online version.

The pound has fallen from $1.60 to $1.48 in just a month. Two years ago, it was trading at $2.00. The stack of $20 bills on my desk, bought a little under a year ago, is now worth 12% more than I paid for them - even with the foreign ATM fees and the bid-offer spread, that's a healthy profit.

The falls would have been even worse if it weren't for the problems facing the Dollar (Obama's spending, particularly the healthcare issue) and the Euro (Greece...) - the Yen is now trading against Sterling at a rate I'd have expected for Dollars five years ago: 133¥ per!


That is the cost of Labour's fiscal policies and of quantitiative easing. We've lost 20-30% of the value of our money and Sterling-denominated assets.

We're all 20-30% poorer than we were a couple of years ago.

And the markets know that, and fear it continuing. A hung parliament with Labour as largest party is the worst of all possible outcomes: no power to make changes, and no desire to, either. Unless there is a clear Tory victory, we're about to become a third-world country. Yes, it is that bad. Guido has already noted that as has the FT. The bond markets are already pricing us as AA, even without a formal downgrade, and uncertainty could easily drive that to A+ or below. If the government can't borrow £180bn/year, it either has to slash and burn spending by something like 20-30%, or devalue Sterling by printing yet more money: we could have lost half of our wealth in just three years.

I predicted double-digit inflation at the start of the year (well, actually in November 2007), and the last month has added upwards of 7 percentage points to the cost of imported goods. Green beans from Kenya, Egyptian potatoes, Korean plasma/LCD TVs, German or Japanese cars, oil, gas, Brazilian "British" beef, all likely to be several percent more expensive this year than last. Prices are therefore going to be growing a lot faster than the feeble GDP recovery we're seeing: the dreaded stagflation of the 1970s.

The current war on bankers could well destroy 30% of GDP - so, around 60% of private-sector production, given our bloated public-sector - which would be crippling. As much as people might hate the banks, we simply cannot afford to lose them. The riots in Greece could, and probably would, happen here if the necessary public-sector cuts were forced (by market action) to be taken quickly - 2m jobs lost overnight, if a debt auction is refused.

Brown must go, it's that simple.

- KoW

Climbing Mount Improbable

I've touched on this before, but Mark Thoma has another sound reason for why we need a new Glass-Steagall act - the evolutionary pressures on banks. The argument is quite elegant, really.

Given a choice between a retail-only bank and a bank that's 99% retail but has a small investment-banking arm, the latter will (in the boom times) show greater profits and dividends, hence will be preferred by shareholders. This encourages them to play the markets, rewards those who do, and punishes those who do not. Similarly, a highly-levered bank will turn greater boom-time profits than a less-leveraged one - so anyone not using as much leverage as possible will turn lower profits and hence be less "fit". Thus banks are encouraged to do ever-riskier things with their money.

In nature, what stops risk-taking behaviour is death and serious injury: we've been conditioned by millennia of evolution to have various rational (and irrational) fears precisely because heights and snakes and fire and dogs are dangerous, and fear is nature's way of codifying that hard-won knowledge for the benefit of the species.

But that doesn't apply to banks now: they're too big to fail, the governments have implicitly (and explicitly) guaranteed their survival. Risk-taking no longer has any risk, so leverage to the hilt and trade whatever instruments offer the greatest upside - there is no downside, thanks to the taxpayer! Departments will keep on growing, as more people and more trades means more profits, making the banks bigger and hence securing their existence.

Whether this is a conscious decision to pursue short-term profits at all costs, or just organic growth of companies and teams who the markets reward for their success, is largely unknowable and almost completely irrelevant. The lesson from evolutionary biology is that a species without natural predators will specialise to an alarming degree, even to the point - like the dodo and the kakapo - where their survival is threatened by even the slightest shock, and a mildly-bored housecat can decimate the population. With no predation, and financial gravity repealed by governments, banks will maximise their profitability by becoming huge and fragile: exactly what we saw in the 1920s and in the 2000s.

The cure is simple, and was correctly enacted in 1932: separate the retail banks (who must be saved) and the investment banks (who can take risks... but who might be killed by them).

- KoW

February Snippets

A400M Saved

EADS has agreed a plan with European governments to save the A400M. This is a good thing as, even though C-17s are lovely and carry huge amounts (~170,000lbs), we can't afford more than half a dozen of them... which means that our air bridge might have lots of capacity, but not enough actual planes to use it. The A400M is half the size (~82,000lbs capacity) and half the price of the C-17, so the capacity is less "lumpy" - rather useful with our diverse commitments. We need something to replace the clapped-out C-130Ks and C-130Js - the Hercules was a fine aircraft, but the oddly-shaped cargo space and now rather small carrying ability means it's well past its sell-by date. The A400M will fill that role nicely, giving more lift into the bargain.

Plus, of course, keeping the ability to build large cargo transports is useful if we don't want to have to rely on the US.


Iceland bankruptcy

The Icelandic negotiators have walked away from meetings with the British and Dutch, refusing to pay anything above LIBOR on the €4bn Icesave debt. Since LIBOR measures short-term rates (various components from overnight to 1 year), Iceland is demanding long-term repayments below the yield curve - i.e. they want to turn their defaulted debt into a loan at below normal market rates.

Iceland is unable to access IMF cash until it reaches an agreement on repaying its debts, and - as the CityAM article notes - this walk-out is likely to result in their sovereign debt being downgraded by the ratings agencies. After all, if someone has just walked out on one obligation, wouldn't you want to charge a bigger risk premium to deal with them?


UK General Election

With Q4 GDP now revised to being +0.3% on Q3, and Labour closing the poll gap despite Bullygate, there is a lot of talk about whether the election will be called this weekend. This has to be at least 17 working days in advance, and a visit to the palace this weekend would mean a March 25th General Election.

I've got a bet on this, doubled since the GDP revision was announced, but we shall see. There are good reasons for a snap election - avoiding the Chilcot inquiry (and hence questions about how he slashed defence budgets and vetoed helicopter purchases), no need to present a Budget, the Q2 GDP figures (likely to show a double-dip from the VAT rise and snow hitting sales) won't be out until late April, and the tax rises on April 5th announced previously still won't have kicked in - but the Labour party is still skint and has to fight local elections on May 6th no matter when the general election happens. Plus there's Gordon Brown's personality - he "bottled" the 2007 election, and I don't think he's in any hurry to face the electorate. Could go either way.

My head says that it'll still be May 6th, but my heart says the election will be called this weekend.

- KoW

Iceland Strategy

A quarter of the population of Iceland have signed a petition asking to be let off for the country's debts.

They didn't seem to mind when the billions in cash were flowing into Iceland, but now they've pissed it all away they don't want to give any back. Hmm. Pretty sure that's not how it works.

Since the debt is in Euros, Iceland can't just devalue its currency and inflate away the debt (and its assets). Iceland can, of course, default on its debts - but as an isolated volcano in the North Atlantic that's not going to help much, as tariffs on (needed) trade will just claw the debt back another way. There's the option that everyone the UK and Holland would like: paying up (over a couple of decades).

Or there's a fourth option: prostitution. Get someone else to pay the debt for you, in return for... services. There are three candidates I can see there: the US, the UK, and Russia.

The UK, despite overwhelming naval superiority, lost the Cod Wars - the expansion of Icelandic fishing rights from 4nm in 1958 to 200nm in 1976. We could take that back, write off our portion of the debt, and revitalise the northern ports - Hull (Alan Johnson and John Prescott), Grimsby (Austin Mitchell since 1977) and Fleetwood. A Labour government so profligate with tax money should easily be able to afford a bung to its heartlands, and might even be able to turn a profit if fishing rights were negotiated well.

Russia doesn't have much access to the Atlantic for shipping, and its submarines are tracked by the sea-bed sonar across the GIUK Gap. Strategically and commercially, Iceland is in a prime location for access to the West. It is also a good source of geothermal power, if the Russian oil/gas oligarchs want to broaden their remits. Of course, the Russian ambassador has publicly refused to get involved.

The US, until 2006, maintained an airbase at Keflavik as Iceland was recognised as strategically important in the Cold War. Given the still-endemic fear of "commies" in the US, if Russia were to show an interest in Iceland then it would be easy to find the money to reopen the base and thereby pump enough money into the economy to pay off the debts. If there's no Russian interest, the US has already shown its intentions by closing NAS Keflavik.

I can't see the EU being interested - too many internal squabbles and no real interest. The most likely involvement would be on trade tariffs if Iceland should default on her debts. China would probably love to help, to be owed a favour, but is literally too far away.

Of course, nice though it would be for the UK to get involved and get some fish to go with our chips, we have already shot ourselves in the foot by invoking anti-terrorist legislation to seize Landsbanki assets when the problems started. So that's about as hostile a relationship as you're going to find anywhere outside of a divorce court.

I think Iceland are screwed.

- KoW

Metro Journalists Cannot Count

The front-page story on today's Metro contains some absolutely ridiculous numbers. They try to put the £850bn total of taxpayer support to the banks in terms of other spending, saying

The figure is more than the entire NHS budget, almost three times the annual defence budget and more than five times what Britain spends every year on transport.

This is complete nonsense. £850bn is not "almost three times" the defence budget, it's closer to thirty times it!

The 2009 budget is here, on the Treasury website. Chart 1.1 on page 12 (the 18th page of the PDF, just to be annoying) shows a total budget of £671bn (against total receipts of £496bn, but what's a £175bn overspend between friends?). £850bn is nearly twice the total receipts, and a quarter more than the budget.

Of the budget, defence gets £38bn, transport £23bn and the NHS £119bn. If "the figure" were £117bn or £131bn (other numbers mentioned in the article) then the comparisons might hold - we have already spent more than it costs to run the NHS for a year or the armed forces for more than three years. Including the guarantees/liabilities adds nearly 90% of GDP to the country's balance sheet - so much for the "golden rule" of debt not to exceed 40% of GDP!

As an aside, £850bn is around 20 months' defence spending for the entire planet put together.

- KoW

Quantitative Easing

So, the Bank of England is to print another £25bn to pump into the economy, but it will be spent over three months (half the previous rate). By my calculations, that means a shortage of about £8bn/month between QE and the government's borrowing - previously they were about the same. Are the global money markets able to pick up the slack

Now, obviously, the BoE cash isn't going directly to public-sector borrowing - that would violate EU law - but it is going indirectly, giving the banks a profit margin from buying new-issued Gilts and then selling them on to the Bank. The net flow is the same, though - newly-printed money is supporting the government deficit, and there'll be less of it in the near future. The further dilution of Sterling is unlikely to appeal to potential investors, though the "small" delta here probably won't make much difference in the short term; likewise, it's probably too small to have a significant effect on exports.

Which all adds up to bad news for the hopes of getting out of the recession this quarter - if the government can't push enough money through the economy, it can't raise GDP, which means no "technical recovery"...

- KoW

Snippets

So, lots of things happened yesterday, and I don't have time to post on all of them individually.

Václav Klaus, the Czech President, became the 27th and final leader to ratify the Lisbon Treaty. It will now come into effect from December 1st, creating official President and Foreign Secretary roles and changing virtually all EU-wide lawmaking from unanimous to majority decisions. This, in the language of the EU, is "simplification" rather than a ratcheting up of power. I'm anti-Europe, but I don't think this change is as catastrophic as others have made out - in particular, we now only need a majority vote to begin repatriating our sovereignty, and centre-right politics are in ascendance across the continent.

Since this is now unavoidable - unless some kind soul were to cause a general election in the next four weeks - I support David Cameron's decision to drop the referendum calls. As William Hague says, it's pointless - it can't unratify the treaty and it's too late to stop it. The idea of putting it in as a manifesto pledge is much better. Unlike a referendum which might go either way (see Ireland), a Tory victory will guarantee a mandate for action - and, if the polls are to be believed, such a victory is on the cards. I guess we'll see what Cameron has to say today.

There's been another huge bail-out of the banks by the UK government - £40bn more thrown at RBS and Lloyds. Alex was in quickly with the news, and reports on today's FT coverage. "Worlds biggest bank bailout" as Metro's front page shouted. City AM leads with the story as well, but focussing on Neelie Kroes' influence.

GM has pulled out of the Magna/Opel deal, which is probably bad news for the Vauxhall workers - GM is now going cap-in-hand to the UK and German governments. I can't see Lord Mandelson changing his stance, especially as finances are getting ever tighter, and the German promises were for a different deal and were made prior to an election that's now happened - very easy to change.

M&S are now selling other brands - I thought this was nationwide when they started the trial in April, but apparently it is now. Good. I don't buy shoddy own-brand colas. This now makes their lunch deal much more attractive as I can get a bottle of Diet Coke with the much-better-than-Boots' sandwiches.

Toyota has pulled out of F1, with immediate effect. Poor Kamui Kobayashi... I hope he can get another drive after his fantastic performance in the last two races. If not, we should support him by going and eating sushi at his family restaurant! Bridgestone are going, too, which is a shame. I was hoping there'd be tyre choice back on the strategy menu now that fuelling is off.

- KoW

Why regulation CANNOT work

There is an interesting paper discussed here on derivatives and computational complexity - the paper makes the case that, while it may theoretically be possible to value a CDO, in practice it is likely to require intractable amounts of computation. They reduce the pricing problem to the Densest Subgraph problem, which is believed to be NP Complete (read that as "impossibly slow" if you're not interested in the details), and also show that some deliberate fraud in the CDO construction would be undetectable. Essentially it would be the same difficulty as factoring a large number - which is so hard it's used as the basis for cryptosystems.

The paper is an interesting read, and suggests that neither counterparties nor regulators nor ratings agencies could hope to know the true situation, even after the fact. That obviously implies a lot more risk than people were expecting. Hindsight is 20/20, eh? Future regulations will hit the same problem, though - there are some theoretically calculable things that you just can't work out fast enough, and we're not talking "a few days" here, we're talking "billions of years". The FSA can't do the risk calculations here, and nor can anyone else.

Ken's comment down at the bottom of that blog post makes a much more important point: it's possible to construct undecidable derivatives. I'd have gone one step further, had a paper C which pays out if B doesn't - making it superficially similar to A - and have the holdings consist only of C. With that chain, the solution isn't just unknown, it's unknowable: C will pay out if - and only if - C doesn't pay out.

This is fundamental computation theory, closely related to the Halting Problem and some mathematical results (Russell's Paradox, Gödel's Incompleteness Theorem). If the FSA had infinite computing resources, they still couldn't solve it. No matter how smart the people involved are, or how fancy the techniques, or how shiny the machine room, it's impossible. Truly, mathematically, impossible.

It follows from this that Mervyn King is completely right: the solution is to firewall the retail banks from the risks in the market. You can't tax, or risk-weight things which cannot be calculated. If two "casino" banks want to tie themselves in knots over undecidable derivatives, fine - their lawyers can make money negotiating a solution, and if one or both collapses, so be it. But the banks we rely on have to be insulated - and this can be done.

Undecidability only exists in "sufficiently powerful" computation models. Arbitrary derivatives are clearly sufficiently powerful. Long positions are not, even when the companies and funds own shares in each other. The solution, and it's a nice simple one, is to work out what instruments a retail bank can safely trade in, and limit it to only those things. You could even let the bank invest some small amount of its assets in a dodgy-as-you-like hedge fund - with the proviso that it can expect to lose 100% (but no more) of its investment and plan the risk accordingly.

Northern Rock may still have collapsed, of course - it made very poor lending decisions - but its assets would have been snapped up as a going concern. All people would have noticed is a change in the letterhead on their statements. Bear Sterns and Lehman Brothers couldn't have affected the high-street banks, as they wouldn't have been allowed to gamble on them - and the other investment banks (Goldman Sachs, et al) and their shareholders would simply have had to eat their losses. Rather than the taxpayer.

- KoW

EC insists banks pay larger bonuses

On page 2 of City AM this morning is a story entitled 'EC gets tough on derivatives'. Apparently the European Commission plans to drive more derivatives trading onto exchanges and hence "under the gaze of regulators".

I think this is great. New categories of exchange-traded instruments means loads more front-office IT work doing exchange connectivity, more autotrading, and - since it's not possible to get everything 100% perfect at 8am on Day One - a lot more opportunities for arbitrage and high-frequency trading. The banks or hedge funds with the quickest developers and the sharpest quants always have a new market to themselves for a while, and make a ton of money off the low-hanging fruit. I expect to see some great short-term (<1s) opportunities where price movements in the underlying asset aren't reflected in the derivative price but there is sufficient liquidity on the exchange to execute a trade. Which, of course, means more profits for the bank (yay!) and large bonuses all round (yay!).

Good to see that the Law of Unintended Consequences is still in effect!

- KoW