Archive for July, 2012

Libor 2 – What Should Actually Scare You

Two posts in one week – not my normal style.  I promise not to inflict this on you again.

After my post on Libor the other day, my friend Bill eloquently busted my chops.  If you haven’t read his comment, you should.  He made an eloquent case that the ends never justify the means, and did it all while quoting Nietzsche.  I am humbled.  Bill, if I am Man, you are Superman.

There, I’ve done it – a blog post containing a Nietzsche joke.  OK, not a great joke, but Nietzsche wasn’t exactly a barrel of laughs.

If I were wise, I’d quit while I’m ahead.  I’m not wise.

Here’s what the Libor scandal reveals that all of us should find much scarier than the actual rate fixing.  A recent article in the Wall Street Journal states:

“More than $800 trillion in securities, derivatives and loans are linked to the Libor, including $350 trillion in swaps and $10 trillion in loans, including auto and home loans.”

$800 trillion is a lot of money.  Except that it’s not actual money.  Global GDP – the total size of the world economy – is $70 trillion, which coincidentally is also about the size of the global money supply.  So Libor-based obligations alone total more than 11 times the actual amount of money in the world.  That doesn’t count non-Libor based obligations – which include at least $250 trillion more in derivatives.  (The total derivatives market is estimated at $600 trillion, from which I’ve subtracted the $350 trillion of Libor-related instruments cited by the Journal).

Derivatives are supposed to make it easy and inexpensive to hedge real risks.  But what we have is a massive, inverted pyramid – something on the order of a quadrillion dollars of exposure precariously perched on top of a “mere” $70 trillion of real money. That feels more like a time bomb than a market.

What can we do about that?  Here’s an idea.  How about a law stating that you can only use derivatives to hedge real assets or liabilities.  By “real” I mean “we can find it on your balance sheet.”  How to enforce it?  Let’s employ the Saudi system of justice – punishment that far outweighs the crime.  It works like this:  “We’re going to conduct spot audits.  If you hold a derivative for which we can’t find the corresponding real asset or liability, we’re going to take you out back and cut off your calculator.”

Admittedly, I’m being impractical here.  A law like this would have to be enacted and enforced everywhere.  But getting back to an environment in which financial markets support real economic activity instead of overwhelming it sure feels like a good idea.  It would also be a world in which we wouldn’t need to be grateful for little – or big – white lies.

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Little White Libor

The big problem with the Libor rate fixing scandal is that no one seems to be able to figure out who the victims were.  Barclay’s has been fined $450 million and had to fire its top three executives.  Four other big European Banks are now in the spotlight, and it won’t be long before Citi, JP Morgan and Bank of America follow them.  Attorneys general around the US are trying to figure out whom they can prosecute for what.  But they’re having a hard time because it isn’t obvious who, if anyone, got hurt.

Libor is the only interest rate I know of that is neither promulgated by a single institution (which is therefore accountable for it) nor based on actual transactions (which makes accountability moot).  Instead, at 11:00 AM (GMT of course), a bunch of unnamed “contributor banks” selected by the British Banking Association call Thompson Reuters and report how much they’re paying to borrow (not how much they’re charging to lend) short-term money from other banks.  Of course, not all of them are borrowing at any given time, so they are also allowed to report what they would expect to pay if they were borrowing.  Like the judges’ panel at a gymnastics meet, Thompson Reuters throws out the top and bottom quartiles, averages the rest, and then publishes that number as today’s Libor.

That “expect to pay” thing makes Libor pretty much a made up number.  At a bare minimum, it’s an open invitation for monkey business.  The number it produces has about as much integrity as the scores at the aforementioned gymnastics meet.

So, what did the monkey business look like?  As best I can piece it together, here’s what happened:

In August of 2007, a full year before Lehman failed, Bank Paribas announced that it was “freezing” three big mortgage-backed security funds.  The problem, Paribas said, was not that the funds had lost too much value, but that the market for the securities in those funds had become so illiquid that they couldn’t figure out how to value them at all.

Understandably, this made other banks with large exposure to the mortgage market (that would be “all of them”) nervous. So nervous, in fact, that they stopped lending to each other.  Each of them apparently was afraid that any other bank they lent overnight money to might not be around in the morning to give it back.

I have no idea what exposure these banks may have had to derivates that would have cratered if Libor had gone up.  I am pretty sure, however, that none of them wanted to admit publicly that its peers no longer found it creditworthy.  So they engaged in a few backchannel conversations and decided to report that they expected to pay about what they’d been paying.

I’m not a big fan of collusion or lying.  Unlike the morally bankrupt children of London and Paris, I learned all about George Washington and the cherry tree in primary school.  But the question of who got hurt is a good one.  I’m pretty sure that if interest rates had jumped 5-10 points in the fall of 2007, what we experienced as a meltdown would have been a full-blown crash.  It’s hard to imagine it being much worse than it was, but a DePaul finance professor told me the other day that the underlying conditions in 2007 were in fact much worse than they were in 1929.

It’s impossible to justify the means, but the ends seem like something we should be happy about.  Price fixing laws exist to keep prices from being artificially inflated, not deflated.  I can’t wait to see the lawsuit that says, “You boys have been brought before this court because you kept interest rates too low.”

This is what former Barclay’s CEO Bob Diamond looks like.

If you see him on the street, which I guess is where he hangs out these days, I think you should give him a hug.

Putting that New iPad to Work

Sometime soon, I may have something serious to say about the Libor rate-fixing scandal.  First I have to see if I can figure out what actually happened.

Until then, here’s something for those of us who just can’t quite figure out how an iPad would make our lives better, even though we know tons of people who swear it would.  This 30-second video is in German.  What?  You don’t speak German?  Don’t worry about it.  It starts, I’m told, with “So, Papa, how do you like the new iPad we got you.”  That’s all you need to know.

Thanks to my friend Spencer Rice for sharing it with me.  I hope it brightened  your day like it did mine.

Maytag Repairmen and Ponzi Schemes

Last week, I met my friend Jeff Bishop for early morning coffee at our local Starbucks.  Jeff has a remarkable talent for making other people feel better about, well, pretty much everything.  I’m tempted to say that he should bottle it and sell it.  However, while that would make him wealthy, it also would make him less exceptional.  I think exceptionalism wins.

There’s a Maytag retail shop a few doors down from the Starbucks.  One of their repairmen was sitting there when I walked in, sipping coffee and looking like he had no particular place to be.  It was too early for a coffee break – more like the time of day when repairmen should be loading up the van for a day of service calls.  If he had a full slate – for that matter, if he had ANY – service calls to make, it sure didn’t show.  Life imitates advertising.  He left and was replaced about 20 minutes later by another Maytag repairman.  Wash, rinse, repeat.  Life imitates advertising twice in one morning.  Perhaps the appliances really ARE that good.  As to why the store has at least two repairmen with nothing to do, that’s a question for another day.

My conversations with Jeff always touch a wide range of topics, mostly business, but we spent a few minutes talking about Social Security.  So a few thoughts on that:

MSNBC, which is terrific before 8:00 AM, has been running a promo spot in which Rachel Maddow, who tends to get her facts right and her interpretation wrong, says that in the midst of our economic struggles, seniors are actually doing pretty well. This, she says, demonstrates that Social Security is working and is not a Ponzi scheme.

My friend John Muller points out that to the extent Social Security actually is helping older Americans, it’s not because it’s working, but precisely because it IS a Ponzi scheme.

I question how much Social Security really helps.  The total amount that we spend is huge (more than $700 billion), but it’s spread over a population of more than 40 million people.  I’ve been managing my mother’s financial affairs for the past year or two.  This is the first time I’ve seen Social Security at work in someone’s life.  Her monthly benefit is below average, but she lives a pretty modest life, and Social Security still covers less than 10 percent of her expenses.  A very small dent.

In fact, the main reason that seniors are doing well is that many of them bought houses when they were priced on the basis of a single income.  There was a huge run-up in residential real estate prices from the late 70s through the late 80s or early 90s, as one market after another was re-priced to reflect the shift to two-income households.  This was a one-time step-up in value, and therefore in the wealth of people who owned homes at the time.  I wish I had a citation for this.  Forbes or Fortune did a terrific article on it many years ago, but I can’t find it.  I remember it saying that what had happened over a decade or two was that Mom went to work in order to transfer a huge amount of wealth to Grandma and Grandpa, who were at a point in their lives where they should have been spending down their estate, not adding to it.

Anyway, I digress, which I’m sure comes as a shock to my handful of regular readers.  Back to the Ponzi scheme.

Social Security was enacted in 1935.  The retirement age required to qualify for full benefits was set at 65.  Around 2000 (yes, 65 years later), a process was put in place to raise it slowly to 67.  We’re about halfway there, and when we finally arrive, we will have achieved a 3% increase in the retirement age.

In 1935, however, the average American life expectancy was 62.  The actuarial expectation was that few people would ever collect benefits, and those who did wouldn’t collect them for long.  No wonder there wasn’t a cost of living adjustment.

Today, the average American life expectancy is 79, a 27% increase over 1935.  If the retirement age had kept pace, it would now be 83, and we would be spending perhaps half a trillion dollars less.  (That’s trillion with a “T”.)  I know we can’t make that happen immediately.  But given the small-dent character of Social Security, it seems to me that a fast, forced march might be a good idea.  I can hear my more liberal friends cringing, but I gotta ask:  If setting the retirement age above the age of life expectancy was good enough for FDR, isn’t it good enough for us?

Enough on that sorry subject.  I hit 50 great balls on the driving range this morning, and then went out and shot 102.  I also had a great time.  This is golf, which is life, imitating the rest of mine.

Pin the Tax on the Donkey

The latest Time magazine arrived yesterday. John Roberts is on the cover, staring knowingly into the distance. He must be looking ahead to all of the Federal mandates that will be passed as a result of his ruling last week on the health care law.

A few friends have asked me what I thought of the court’s ruling. My short answer: Knock me over with a feather. I was sure that the Roberts Court would strike the individual mandate down. I would have been disappointed because I think anything that moves us away from employer-sponsored health insurance is a good idea. Obamacare doesn’t go nearly far enough, but is a step in the right direction. That said, I certainly didn’t think the mandate would be upheld on the grounds that the penalty associated with not having health insurance is a tax, and therefore is well within the province of the Federal government. I suppose it’s worth pointing out that the law’s proponent’s didn’t think so either.

I’m not a lawyer. It coulda happened, and I give thanks daily that it didn’t. But in my ignorance, I thought courts had to make their decisions based on the merits of the arguments placed in front of them by the litigants. I had no idea that they could find or make their own arguments. This (in my humble opinion, anyway) is an astounding act of judicial activism. And if you believe the humble part, I would like to talk real estate with you.

The Wall Street Journal published an editorial a few days ago that I think got this right. Roberts’ ruling, the Journal said, creates a precedent that expressly allows the Federal government to mandate pretty much any behavior it wants as long as there is a financial penalty attached to your failure to engage in that behavior. You can read the Journal’s editorial here.

This is the largest expansion of government authority that any of us will see in our lifetimes. And it was not only presided over, but was crafted by a supposedly arch-conservative chief justice who was appointed by that wilting violet of liberalism, George W. Bush.

The healthcare law will be vilified as a massive tax during the upcoming campaign, and for other reasons that have little to do with its incompleteness or other flaws. Meanwhile, this massive increase in Federal authority to mandate behavior will, I suspect, go largely unnoticed.

Happy Dependence Day.


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