Felix Salmon

Many thanks to Stanford’s Darrell Duffie for leaving a comment on my last post about Libor. Duffie is one of the academics who signed off on the WSJ’s attempt to prove the measure flawed, so he’s probably disappointed that the BBA has decided to do nothing, for the time being, to change it. I, on the other hand, think the BBA made exactly the right decision. Yes, there are problems with Libor, just as there are problems with any market yardstick. But the problems aren’t huge, and rushing to fix them might well involve unintended consequences – not least that Libor rates, which are generally considered too low, might actually fall further.

Duffie talks of a few proposals for fixing Libor suggested by Terry Belton Bolton of JP Morgan. In fact, however, after running down the list of proposals, Belton concludes that none of them is a particularly good idea, on the grounds that they would generally either have negligible effect or that they would actually drive Libor lower. Still, it’s an interesting list, and worth sharing. And given that the BBA has said that they "will be strengthening the oversight" of Libor, whatever that means, it’s even possible that one or two of these might be adopted.

• Increase the size of the panel. At the moment, it is quite heavily UK-focused. But if more US banks were added, what would happen? The obvious ones, like Wachovia and Wells Fargo, tend to fund through deposits rather than in the wholesale markets. At the margin, that would tend to drive Libor down, since the banks in it would on average have less demand for interbank funds.
• Change the time of the quote. This seems to have been dreamed up by US bankers who don’t like having to be alert at 11am London time. But, says Belton, "with a global index and a round planet time will always be a

  problem for somebody," especially since 13 of the 16 banks on the panel are based outside the US.

• Change the calculation to use a median rather than a

  trimmed mean. At the moment, the BBA discards the four most expensive and four least expensive quotes, and takes the average of the rest. Which is one reason why the attempted WSJ takedown was underwhelming: if the banks with the most credit risk reported higher borrowing costs, they’d likely be discarded from the calculation anyway. But what would happen if the BBA just used the median number instead? Belton did the math, and concluded that Libor would rise by less than one sixth of a basis point in crazy times like now, while "under more

  normal circumstances, such as in early 2007, we expect the

  statistical difference between the two measures would be

  statistically imperceptible."

• Change the survey question. At the moment, banks are asked what it costs them to borrow money on the interbank market; the Euribor survey, by contrast, simply asks what the interbank rate is. Would this have much of an effect? It’s easy to answer that: just look at the difference between Euribor and euro Libor. It turns out to be about a quarter of a basis point: there’s "no statistical significance

  to the different averages," says Belton.

It’s doubtful that the first proposed change will happen: if it were going to happen, it would have been announced by the BBA on Friday. The others are basically tinkering at the margin, and would make Libor behave a bit more like Euribor. I suspect, however, that if Euribor had the amount of scrutiny of late that Libor has come under, it, too, would have shown weaknesses. Unless someone can compellingly demonstrate that Euribor is superior to Libor, both in theory and in practice, I see no reason to change Libor.

Did you have time to read more than 10,000 words by Kate Kelly on the fall of Bear Stearns? It’s an interesting series, full of color. My favorite bit is Jamie Dimon vs Vikram Pandit:

Late Sunday night, as lawyers raced to finalize the merger agreement, executives of the New York Fed convened a call for Wall Street CEOs…

Mr. Pandit — who did not initially identify himself — asked a shrewd but technical question: How would the deal affect the risk to Bear Stearns’s trading partners on certain long-term contracts?

The query irked Mr. Dimon. "Who is this?" he snapped. Mr. Pandit identified himself as "Vikram." Offended that Mr. Pandit was taking up time with what he considered granular inquiries, Mr. Dimon shot back, "Stop being such a jerk."

For a smart critical reaction to the series, check out Dear John Thain (1, 2, 3). He explains why it made no sense for Bear to unwind its "chaos trade", and wonders, as I do, what "a nonequity stake of as much as 10% in Bear Stearns" might be – apparently Pimco was in talks to acquire such a thing, but the talks fell apart. He also asks why Bear was so convinced that it could file for Chapter 11 bankruptcy, when there was no reason to believe that any brokerage could do such a thing.

My feeling after getting through the whole thing was that if there was one main cause for Bear’s demise, it was simply mismanagement. The people in charge were good at taking risks in bull markets, but very bad at managing risks when credit markets were getting crunchy. They found reasons not to raise equity, they bickered with each other, and they had zero goodwill to draw on from the rest of Wall Street. No one wanted to rescue Bear, and Hank Paulson, in particular, was adamant that it should be done with as much pain as possible to Bear’s shareholders (who, of course, were largely its employees).

Put it this way: if Morgan Stanley or Lehman Brothers had been in Bear’s position, the story would likely have been much happier. They have friends; Bear Stearns simply didn’t.

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.