Capital Markets Update

By Louis S. Barnes　　　　　　　　　　　　Friday, July 6th, 2012　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　　

First some data, then Libor. Tempest or titillation? The effects from global markets to your adjustable-rate mortgage — earth-shaking? Or teapot-tilting?

June jobs data are as-was in May and April: 75,000 new jobs, poor, but afloat! The June ISM data is more concerning, overall to 49.7 from 53.5, and “internals” crashing: new orders down 12.3 to 47.8, and prices of raw materials collapsed another 10.5 to 37 (inflation risk is zero). For comparison, China and all of Europe are lower in the 40s, Spain below the 44 marking serious recession.

Libor. London Inter-Bank Offered Rate, complied by the British Bankers Association since 1986. Compiled by survey, not independently verifiable market benchmark, posted at 11AM GMT each day in maturities overnight to one year and in 10 currencies.

All floating-rate IOUs are tied to an index of some kind, the chatter on trading floors all day every day “over” — over US Treasurys, British gilts, German Bunds, over Libor. Nobody knows how many hundred trillion dollars’ worth of securities are tied to Libor.

The first US ARMs appeared in volume in 1980, most commonly tied to COFI, 1-year Treasurys, and Libor, each plus a spread, aka “margin.” COFI was the average cost of a deposit to an S&L in CA, AZ, and NV (only). Yes, the rate you paid to an S&L was determined in part by the rates that it decided to pay its depositors. Margins ran from over 3.00% to below 2.00%. COFI loans were a Bubble casualty, finished by Lehman.

The Treasury stopped selling 1-year T-bills in 2001 because we were in budget surplus (what a thought…), and before it began again in 2008 the index value in your mortgage adjustment was inferred by statistical artifact (CMT). Fannie margins for this most-common index have been 2.75%. However, the Fed at 0% since 2008 has pulled the 1-year down to 0.19%, farther than ever imagined, and T-bill-tied ARMs are scarce.

If you have a one-month, three-month, six-month, or one-year Libor ARM, you pay 2.25% over the equivalent Libor maturity. The 0.50% difference between margins over Libor and T-bills reflect the ’80s-’90s spread between bills and Libor. Not now! One-year Libor is 1.069% today, plus margin a “pay rate” of 3.319 versus a T-bill-tied 2.94%.

Every ARM promissory note contains a provision for a replacement index (un-named) if the one in the note becomes “unavailable.”

Back to the tempest. Apparently between 2005 and 2010 bankers surveyed by the BBA began to fib on the low side. To what effect — magnitude — nobody seems to know, but in an index measured to three decimal places, not much. But, a hell of a lot of money moves by each one-thousandth. Some motivation to fib was ordinary cheating, but some was self-protective, not wanting to tell a panicked world how much your bank had to pay for funding.

Everyone in the market knew that Libor was somewhere between inexact and imaginary, and banker-determined; regulators knew that the BBA survey had “irregularities”; and the financial press routinely ran stories about Libor rigging. Everybody-does-it is a poor defense, but deep inside inexact markets everybody must stick a wet finger into the wind and announce velocity.

Everybody does something else: everyone wants precision in life beyond our ability to have it. Thus we live in constant, comfortable, and fabricated illusion, and we are enraged when our self-deceptions are exposed.
To have rigged Libor was a Bad Thing. The downside rig did cause losses in some heavily structured finance — “inverse-floaters” — hurting those who tried to outsmart future interest-rate probabilities.

To have rigged Libor during the greatest bank run of all time, every financial institution and the system itself facing panicked suspicion… that was a Stupid Thing. The stupid should resign forthwith.

However, relative to our current predicament and bad deeds private and public, this Libor thing is whitecaps in a thimble. A microscopic storm has morphed into yet another hysterical witch-hunt. Be damned careful. There are good witches and bad ones, and when the bad ones are loose you’ll wish you hadn’t dropped a house on your good one.