Defending Libor

Carrick Mollenkamp and Mark Whitehouse got some pretty heavyweight backing for their Libor investigation today: before running it on the front page of the WSJ, they got sign-offs from

Darrell Duffie of Stanford, Mikhail Chernov of London Business School, and David Juran of Columbia. In the blogosphere, their findings have been received uncritically by Ryan Chittum ("Lying about Libor" is his headline), Angus Robertson, Paul Jackson, and others.

But Alea is not convinced at all, and neither is JP Morgan, and neither am I.

One thing I find extremely suspicious is the fact that the WSJ’s interactive graphic shows implied rates only back to August 2007, thereby only showing what’s happened since the credit crunch hit. If they went back further, their methodology might be exposed:

Pre-credit crunch, pre-August 9th 2007, when OIS-Libor spread was below 10 bp, the Journal calculation would have resulted in a “risk-free Libor” below the OIS fixed, a proxy for a risk-free rate.

What’s more, there are lots of places where banks actually borrow real cash, like the commercial paper market. Why would the WSJ try to use credit default swaps to gauge what cash borrowing rates should be, when they can look to something like the CP market instead? Clearly, I think, the answer is that the CP market wouldn’t give them the answer that they’re looking for.

Alea does a good job of explaining the theoretical weaknesses behind the WSJ’s methodology. But my gut reaction that the methodology is flawed was based on none of those. Rather, I mistrust any calculation which assumes that since last summer there has been a clean and predictable and precise relationship between cash credit products, on the one hand, and credit default swaps, on the other. Yes, Libor is a borrowing rate, and yes, there is some kind of credit spread baked in to it. But to assume that Libor equals a risk-free borrowing rate plus a default-risk premium is silly and simplistic – especially when you don’t back-test your model to a time when things were much less volatile.

It’s worth remembering that the interbank markets are based on long-standing relationships which are necessary to any smoothly-functioning financial system. Yes, Citigroup’s credit default swaps might be pricing in a relatively high probability of default, but that doesn’t mean that Citi’s counterparties will charge it a similar premium to insure against default risk, as the WSJ seems to think. Maybe they trust Citi more than the rest of the market does, or maybe they realise that any possible world in which Citi defaults is a possible world in which they’ve got much bigger things to worry about than their interbank lines.

Do I think that Libor is perfect? No. In this world, no spread measure is going to be perfect, especially at tenors of longer than a couple of weeks. But Libor is not nearly as flawed as the WSJ makes it out to be.

What the WSJ has done is come up with a marginally interesting intellectual conundrum: why is there a disconnect between CDS premia, on the one hand, and Libor spreads, on the other? But the way that the WSJ is reporting its findings they seem to think they’re uncovering a major scandal. They’re not.

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8 Responses to Defending Libor

  1. Cosmo22 says:

    Further impeding the WSJ logic is the fact that, if you think Libor is too “bank controlled” to be accurate, what can you say about the market for single-bank name CDS?

    It’s certainly not a market that’s widely traded beyond the same names that contribute to libor and euribor. If Libor is tainted (and the FSA evidence doesn’t come *close* to proving that) then you must assume CDS suffers from the same taint.

    Of course, CDS is traded, not auctioned, but it’s still a function of a small collection of counterparties that, as you say, may or may not reflect a true and accurate representation of risk .

    The logical flaw, then, is to assume one bank-dominated benchmark is “pure” while the other bank-dominated benchmark is “tainted”.

  2. cotf says:


    I guess your next blog post on this subject will be “whoops!”?

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  4. Phil says:

    Just another mouthpiece for the establishment – no worries by the time they figure out the scandal, it will be forgotten – 4 years later – not forgotten. You should quit now.

  5. brian jones says:

    felix salmon=clueless/complicit(?) establishment hack…(at best)

  6. Ed Porter says:

    Nice article – you really nailed it.

  7. Ed Porter says:

    “But Alea is not convinced at all, and neither is JP Morgan, and neither am I”.

    You forgot “and neither is Barclays”

  8. Anonymous says:

    I thought you were an idiot back in 2008….this confirms it…

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