Tim Geithner had a nice chat with Congress about Libor in a theoretically unrelated hearing today, and since Congressional hearings are mostly about restating everyone's pre-existing prejudices I figured I'd lay out my Libor hobbyhorses:
- Nobody really has ever been all that troubled by the fact that banks manipulated Libor to make themselves look like they could borrow in 2007-2008, while everyone is at least acting all shocked shocked that banks manipulated Libor to juice derivatives profits, but that contrast is awkward because in a certain light those are the same activity, so everyone has to look all horrified by stuff they were obviously cool with four years ago.
- Everybody knew that banks understated Libor in 2007-2008. Like, you could compare Libor to market borrowing rates and CDS and stuff, and people did, and noticed it was wrong. Also remember that Barclays, while they were manipulating Libor, were also emailing all their clients every day to remind them that Libor was being manipulated.
- The effect/harm/liability of Libor manipulation has to be determined in expectation and if everyone knew it was being manipulated then they were presumably charging a higher spread to Libor when dealing with banks.
Geithner's testimony won't change my mind: now he has to look all grim about Libor manipulation, while back in the day he "treated it as a curiosity, or something akin to jaywalking, as opposed to highway robbery."
But Tim Geithner wasn't just a regulator when he ran the New York Fed; he was also a Libor user. So he gets to answer questions like this:
In a House Financial Services Committee hearing on Wednesday, Treasury Secretary Geithner was asked why Treasury and the Fed used the London Interbank Offered Rate as a basis for loans to insurance giant American International Group and to U.S. banks under the Term Asset-Backed Securities Loan Facility -- even though Geithner and other regulators had long suspected that Libor was artificially low, as Geithner testified.
"We were in the position of investors around the world," Geithner shrugged. "You have to choose a rate, and we did what everybody did -- use the best rate available at the time."
Not everyone agrees. Mark Gongloff:
Another, less charitable way to look at it is that the Fed was fully aware that Libor was being manipulated lower, and was fine charging an artificially low rate to lend money to banks and to AIG, in what amounted to yet another kind of bailout. Why make life harder for them, right? They had enough problems dealing with the crisis they had created. Raising red flags about Libor might have only made the crisis worse, making it harder for banks to borrow money.
But in the process, the government left untold mountains of cash on the table for U.S. taxpayers. Even if Libor was only manipulated a tiny bit lower, these small breaks add up.
No! I mean, in some sense, sure, untold mountains of cash. Still, no! The government had a cost of funds of X, and it loaned those funds to banks at Y, and it made (Y - X) less whatever defaults occurred. Those things are true if Y was Libor (it wasn't!), or if Y was Libor + some margin, or Libor swap rates + some margin, or fed funds + some margin, or the prime rate minus some margin, or 5% (it sometimes was!*). Y could have been bigger, of course, which may or may not have reduced participation or whatever, but, Libor manipulation is not a unique or interesting reason that it would have been bigger: if Geithner knew that Libor was too low, and he did, he could lend at a premium to Libor, and he did. TARP and TALF were sweetheart deals, and AIG maybe was/wasn't, because they were intended to be sweetheart deals, not because of the mechanics of their rate setting.
A related argument is Neil Barofsky's, which is that Geithner implicitly endorsed Libor by using it in bailout deals while knowing it was broken, so other chumps continued in being deceived because what was good enough for the NY Fed seemed good enough for them. That is I think debatable for bunches of reasons, of which my three favorites are (1) that if everyone else was using Libor before (they were!) the bailout endorsement doesn't matter that much, (2) if everyone knew that Libor was manipulated (they did!**) then the bailout endorsement doesn't matter that much, and (3) lending money to banks at 50 basis points over Libor is not exactly a ringing endorsement of the theory that banks can borrow at Libor.***
Anyway: expectations. The fun thing, I think, is that the least scandalous part of the Libor scandal came in the banks' dealings with the New York Fed. Here is a silly simplified model for those dealings:
- the banks told the NY Fed that they were manipulating Libor, and by how much, and
- the banks borrowed from the New York Fed, at a premium to Libor set by the New York Fed.
If you are the NY Fed in that circumstance, how much premium do you charge? Conceptually, I think you charge Libor (the fake cost of bank borrowing), plus the amount by which you think Libor is understated (to get to the real cost of bank borrowing), plus some sort of option premium for the fact that the banks get to decide how much to understate Libor in the future. That option premium is not, y'know, Black-Scholes-derivable, but that's a detail. Banks pretty regularly enter into trades where their counterparties get paid a premium in exchange for giving the bank inscrutable nefarious optionality on a price fixing.
Everyone else lending to Libor-panel banks, or entering into swaps with those banks, could presumably enact the same self-help. (Remember: they were also getting daily emails telling them that Libor was understated and by how much.****) Liborgate is in some strange sense least problematic when it involved the banks' own dealings: sure they were cheating their customers, but the customers knew it, and in expectation could charge for the right to be cheated. The borrowers and lenders and swappers who used Libor and were not dealing with Libor-panel banks were the sadder cases: they were getting cheated, but didn't have anyone to bill for it.
* TALF had bits priced at 1m Libor + 50bps, fed funds + 75bps, Prime - 175bps, various swap tenors + 100, etc. (OH HEY CAN WE TALK ABOUT HOW THE PRIME RATE, WHICH AFFECTS ELEVENTY KAZILLION DOLLARS OF CREDIT CARD DEBT AND SHIT, ISN'T A REAL MARKET INTEREST RATE BUT INSTEAD A NUMBER THAT COMES FROM A SURVEY OF BANKS WHO MAKE IT UP?) TARP's fixed dividend rate was 5%.
** Here and elsewhere my use of "everyone" is unforgivably loose, markets are efficient etc.
*** LIKE: if you are a bank would you rather borrow (1) by taking out unsecured loans at your alleged cost of 1-month borrowing, or (2) by selling assets into a thing financeable with a haircut at your alleged cost of 1-month borrowing plus 50bps? Choice (2) is nonrecourse, so unfair question, but still, if you could borrow unsecured at Libor you'd at least think hard about borrowing unsecured at Libor rather than effectively borrowing secured at a fifty basis point spread over Libor, no? And if you instead chose to borrow secured at Libor + 50 doesn't that suggest that your ability to borrow unsecured at Libor flat was mostly theoretical? No?
**** By this point "everyone" has diverged widely from reality: municipalities, for instance, were not getting those emails.