LIBOR, the Fed and the TED

LIBOR, the Fed and the TED
David R. Kotok
July 9, 2012

“Insanity: doing the same thing over and over again and expecting different results.” Albert Einstein

Somehow, the insanity of the present unsupervised system involving the Federal Reserve’s primary dealers continues. The Fed had “surveillance” in place during the Drexel Burnham failure and the Salomon Brothers affair. There were no market meltdowns attributed to either event.

Then, in the early 1990s, under the Corrigan initiative and with the approval of the FOMC and Chairman Greenspan, the Fed ceded the surveillance issue to the other regulators. Since this policy change, the toll of primary dealer casualties has grown to include Lehman Brothers, Bear Stearns, Merrill Lynch, MF Global, Countrywide, and now Barclays.

How many more market shocks will we have to endure before the Fed reverses one of the worst decisions it ever made? Until the Fed ceases shirking its supervisory responsibility and restores a more formal surveillance and oversight role, there is no reason to expect things to be any different; and Einstein’s remark applies.

Below is a direct quote from the website of the Federal Reserve Bank of New York. Readers please note that the NY Fed sets the rules for primary dealers. It does not take Congress to change this. The Fed could make this change tomorrow if it chooses to do so.

“The Federal Reserve Bank of New York trades U.S. government and select other securities with designated primary dealers, which include banks and securities broker-dealers. Weekly transaction, market share data and primary dealer lists are updated periodically. Much of the information is submitted voluntarily. The Bank expects primary dealers to submit accurate data, but the Bank itself does not audit the data.”

The LIBOR affair gives the Fed a chance to restore some “audit” of the data.

Below is the latest list of primary dealers, as copied from the NY Fed website (July 8, 2012). We have cross-checked this list against the list of institutions represented on the committee that provides data for the American dollar LIBOR rates. Different institutions sit on other currency-setting committees. Because this commentary is focused on the Fed, we are ignoring the other currencies. In addition, readers may note that some of the firms on the NY Fed list are not banks and therefore would not be involved in setting LIBOR.

Where we could establish a connection between primary dealer status and LIBOR rate-setting status, we have marked a “YES” next to the institution name. If we are unsure of a connection or could not find one, we marked it “NO”. (A special hat tip to Dick Bove of Rochdale Securities for excellent research on the LIBOR scandal; he provided the American LIBOR committee list.)

Bank of Nova Scotia, New York Agency-NO;
BMO Capital Markets Corp.-NO;
BNP Paribas Securities Corp.–YES;
Barclays Capital Inc.–YES;
Cantor Fitzgerald & Co.-NO;
Citigroup Global Markets Inc.–YES;
Credit Suisse Securities (USA) LLC–YES;
Daiwa Capital Markets America Inc.-NO;
Deutsche Bank Securities Inc.–YES;
Goldman, Sachs & Co.-NO;
HSBC Securities (USA) Inc.–YES;
Jefferies & Company, Inc.-NO;
J.P. Morgan Securities LLC–YES;
Merrill Lynch, Pierce, Fenner & Smith Inc.–YES (through Bank of America affiliate);
Mizuho Securities USA Inc.-NO;
Morgan Stanley & Co. LLC-NO;
Nomura Securities International, Inc.-NO;
RBC Capital Markets, LLC–YES (through Royal Bank of Canada);
RBS Securities Inc.–YES (through Royal Bank of Scotland);
SG Americas Securities, LLC–YES (through Societe Generale);
UBS Securities LLC.–YES (through UBS AG)

That’s right, the majority of Fed’s primary dealers also set LIBOR.

Okay, where are we going with this? We are going to the US dollar-based TED spread.

There is a widely reported global investigation underway into the LIBOR rate-setting mechanism. Britain’s Barclays was the first revelation but is unlikely to be the last. The British Banking Association is independent of the Federal Reserve. BBA is investigating in conjunction with the Bank of England and the British Financial Services Authority.

We are interested in the US response. We seek to track the behavior of primary dealers that are doing daily business with the NY Fed. We are looking to see if players other than Barclays participated where one side of the trade was rigged.

Why?

Spreads between LIBOR-based rates and US Treasury securities’ yields are potentially arbitraged in large amounts. Every student of financial markets learns the importance of the TED spread – it’s the differential between LIBOR and T-bill rates. If one side of the TED is rigged, all of it is in doubt. The TED is critical, or was critical. It was (is) used to indicate the market-based assessment of risk in the global banking system. A rigged TED was an unthinkable act. So much for “unthinkability.”

Would Fed oversight and surveillance have prevented Barclay’s actions? We cannot say. Would the threat of losing primary dealer status been a sufficient deterrent? We cannot say. But we wonder what message would be sent if the NY Fed now took Barclays out of the primary dealer lineup for a penalty period. And we wonder what the market will think if the NY Fed does nothing.

We cannot prove any counterfactual about what might have happened if the Fed maintained surveillance. We can say that the record since surveillance stopped reflects poorly on the Fed’s decision.

In her Sunday column (“The British, At Least, Are Getting Tough,” July 8, 2012), NY Times journalist par excellence Gretchen Morgenson closed with this paragraph:

“With each new financial imbroglio, the gulf widens between Main Street’s opinion of Wall Street and the industry’s view of itself. When Mr. del Missier, the former Barclays chief operating officer, took over as chairman of the Securities Industry and Financial Markets Association last November, he said: ‘We will continue to work on maintaining and burnishing the level of confidence investors have in our markets, in our financial institutions, and in the general economic outlook for the future.’ ”

That’s right; the new chair of SIFMA is one of the Barclays executives who just resigned over the LIBOR scandal. SIFMA is a regulator of some of the brokers who are not bank affiliates but who are primary dealers.

Albert Einstein also said, “We cannot solve our problems with the same thinking we used when we created them.” Einstein was at Princeton before Bernanke. We can only hope that the elder Princetonian’s principles influence the younger one to re-impose meaningful surveillance and thereby restore confidence in a system that sorely lacks it.

David R. Kotok, Chairman and Chief Investment Officer