It was easy to miss, with the impending end of civilization burning up the headlines, but a beyond-belief financial story recently crept into public view.
A Bloomberg headline on the story was a notable achievement in the history of understatement. It read:
LIBOR'S UNCERTAIN FUTURE TRIGGERS $350 TRILLION SUCCESSION HEADACHE
The casual news reader will see the term "LIBOR" and assume this is just a postgame wrapup to the LIBOR scandal of a few years back, in which may of the world's biggest banks were caught manipulating interest rates.
It isn't. This is a new story, featuring twin bombshells from a leading British regulator – one about our past, the other our future. To wit:
- Going back twenty years or more, the framework for hundreds of trillions of dollars worth of financial transactions has been fictional.
- We are zooming toward a legal and economic clusterfuck of galactic proportions – the "uncertain future" Bloomberg humorously referenced.
LIBOR stands for the London Interbank Offered Rate. It measures the rate at which banks lend to each other. If you have any kind of consumer loan, it's a fair bet that it's based on LIBOR.
A 2009 study by the Cleveland Fed found that 60 percent of all mortgages in the U.S. were based on LIBOR. Buried somewhere in your home, you probably have a piece of paper that outlines the terms of your credit card, student loan, or auto loan, and if you peek in the fine print, you have a good chance of seeing that the rate you pay every month is based on LIBOR.
Years ago, we found out that the world's biggest banks were manipulating LIBOR. That sucked.
Now, the news is worse: LIBOR is made up.
Actually it's worse even than that. LIBOR is probably both manipulated and made up. The basis for a substantial portion of the world's borrowing is a bent fairy tale.
The admission comes by way of Andrew Bailey, head of Britain's Financial Conduct Authority. He said recently (emphasis mine):
"The absence of active underlying markets raises a serious question about the sustainability of the LIBOR benchmarks. If an active market does not exist, how can even the best run benchmark measure it?"
As a few Wall Street analysts have quietly noted in the weeks since those comments, an "absence of underlying markets" is a fancy way of saying that LIBOR has not been based on real trading activity, which is a fancy way of saying that LIBOR is bullshit.
LIBOR is generally understood as a measure of market confidence. If LIBOR rates are high, it means bankers are nervous about the future and charging a lot to lend. If rates are low, worries are fewer and borrowing is cheaper.
It therefore makes sense in theory to use LIBOR as a benchmark for borrowing rates on car loans or mortgages or even credit cards. But that's only true if LIBOR is actually measuring something.
Here's how it's supposed to work. Every morning at 11 a.m. London time, twenty of the world's biggest banks tell a committee in London how much they estimate they'd have to pay to borrow cash unsecured from other banks.
The committee takes all 20 submissions, throws out the highest and lowest four numbers, and then averages out the remaining 12 to create LIBOR rates.
Theoretically, a fine system. Measuring how scared banks are to lend to each other should be a good way to gauge market stability. Except for one thing: banks haven't been lending to each other for decades.
Up through the Eighties and early Nineties, as global banks grew bigger and had greater demand for dollars, trading between banks was heavy. That robust interbank lending market was why LIBOR became such a popular benchmark in the first place.
But beginning in the mid-nineties, banks began to discover that other markets provided easier and cheaper sources of funding, like the commercial paper or treasury repurchase markets. Trading between banks fell off.
Ironically, as trading between banks declined, the use of LIBOR as a benchmark for mortgages, credit cards, swaps, etc. skyrocketed. So as LIBOR reflected reality less and less, it became more and more ubiquitous, burying itself, tick-like, into the core of the financial system.
The flaw in the system is that banks don't have to report to the LIBOR committee what they actually paid to borrow from each other. Instead, they only have to report what they estimate they'd have to pay.
The LIBOR scandal of a few years ago came about when it was discovered that the banks were intentionally lying about these estimates. In some cases, they were doing it with the assent of regulators.
In the most infamous instance, the Bank of England appeared to encourage Barclays to lower its LIBOR submissions, as a way to quell panic after the 2008 crash.
It later came out that banks had not only lied about their numbers during the crisis to make the financial system look safer, but had been doing it generally just to rip people off, pushing the number to and fro to help their other bets pay off.
Written exchanges between bank employees revealed hilariously monstrous activity, with traders promising champagne and sushi and even sex to LIBOR submitters if they fudged numbers.
"It's just amazing how LIBOR fixing can make you that much money!" one trader gushed. In writing.
Again, this was bad. But it paled in comparison to the fact that the numbers these nitwits were manipulating were fake to begin with. The banks were supposed to be estimating how much it would cost them to borrow cash. But they weren't borrowing cash from anyone.
For decades now, the world's biggest banks have been dutifully reporting a whole range of numbers every morning at 11 a.m. London time – the six-month Swiss franc rate, the three-month yen, the one-month dollar, etc. And none of it seems to have been real.
These numbers, even when sociopathic lunatics weren't fixing them, were arbitrary calculations based on previous, similarly arbitrary calculations – a rolling fantasy that has been gathering speed for decades.
When regulators dug into the LIBOR scandal of a few years ago, they realized that any interbank lending rate that depended upon the voluntary reports of rapacious/amoral banks was inherently problematic.
But these new revelations tell us forcing honesty won't work, either. There could be a team of regulators sitting in the laps of every LIBOR submitter in every bank, and it wouldn't help, because there is no way to honestly describe a nonexistent market.
The FCA's Bailey put it this way (emphasis mine):
"I don't rule out that you could have another benchmark that would measure what Libor is truly supposed to measure, which is bank credit risk in the funding market," he said. "But that would be – and I use this term carefully – a synthetic rate because there isn't a funding market."
There isn't a funding market! This is absurdity beyond satire. It's Chris Morris' "Cake is a made-up drug!" routine, only in life. LIBOR is a made-up number!
Think about this. Millions of people have been taking out mortgages and credit cards and auto loans, and countless towns and municipalities have all been buying swaps and other derivatives, all based on a promise buried in the fine print that the rate they will pay is based on reality.
Since we now know those rates are not based on reality – there isn't a funding market – that means hundreds of trillions of dollars of transactions have been based upon a fraud. Some canny law firm somewhere is going to figure this out, sooner rather than later, and devise the world's largest and most lucrative class-action lawsuit: Earth v. Banks.
In the meantime, there is the question of how this gets fixed. The Brits and Bailey have announced a plan to replace LIBOR with "viable risk-free alternatives by 2021."
This means that within five years, something has to be done to reconfigure a Nepalese mountain range of financial contracts – about $350 trillion worth, according to Bloomberg. A 28 Days Later style panic is not out of the question. At best, it's going to be a logistical nightmare.
"It's going to be a feast for financial lawyers," Bill Blain, head of capital markets and alternative assets at Mint Partners, told Bloomberg.
With Donald Trump in office, most other things are not worth worrying about. But global finance being a twenty-year psychedelic delusion is probably worth pondering for a few minutes. Man, do we live in crazy times.