The Libor And Why You Should Know It

I don't know much about economics. I never took Econ 101, and most of what I know I've gleaned from reading Adam Smith or listening to my father. Not very contemporary or altogether reliable sources, those. I've always wondered what the banks take into account when they set their rates. I know they take the Fed's exchange rate into account, but that does not change on a daily basis. International banking must use a more precise indicator.

They do. It's called the Libor (British Bankers’ Association’s London Interbank Offered Rate). The Libor is the rate at which British money traders make their transactions. You can find all of this out and more in this week's London Review of Books.

Brokers in major money-market currencies don’t work as individuals, but in teams of up to a dozen or more, sitting close together in subsections of large, open-plan offices. Good eyesight is useful – trainees still sometimes called ‘board boys’ write unfilled bids to borrow and offers to lend on whiteboards surrounding clusters of brokers’ desks, and you can occasionally see a broker using binoculars to read a distant whiteboard or screen – but a more crucial skill is ‘broker’s ear’: the capacity to monitor what is being said by all the other brokers at nearby desks, despite the noise and while at the same time holding a voicebox conversation with a client. As one broker put it to me: ‘When you’re on the desk you’re expected to hear everyone else’s conversations as well, because they’re all relevant to you, and if you’re on the phone speaking to someone about what’s going on in the market there could be a hot piece of information coming in with one of your colleagues that you would want to tell your clients, so you’ve got to be able to hear it coming in as you’re speaking to the person.’

When you first encounter it, broker’s ear is disconcerting. You’ll be sitting beside a broker at his desk, thinking he’s fully engaged in his conversation with you, when suddenly he’ll respond to a question or comment, from several desks away, that you simply hadn’t registered. It’s an embodied skill that affects the way Libor is calculated. The inputs to the calculation are provided daily by the money-market traders from banks that are on panels established by the British Bankers’ Association. There is one panel for each currency, and those for the main currencies each have 16 banks on them. What each bank has to provide is the rate at which it could borrow funds (‘unsecured’ – that is, backed only by the bank’s creditworthiness, not more specific collateral – and ‘governed by the laws of England and Wales’), ‘were it to do so by asking for and then accepting interbank offers in reasonable market size just prior to 11.00’ in the currency and for the time period in question.

Fascinating. One benefit of entering the New Depression is that you get to learn all this quirky knowledge about how things worked before the fall. Kind of like learning how to do a post-mortem during a post-mortem.

Econ 101

It has been a wild two weeks for the American economy, and we haven't hit bottom yet. We should prepare for the worst, and readjust our expectations that the good times are just around the corner. Many Americans have an asset problem right now. Their savings are tied into their homes and their 401ks, two products that have not grown for a few quarters. We do not have true savings, and thus zero liquidity. In an economic downturn, this is BAD news. My father taught me from an early age to always, always have cash at hand. We Americans must save our way through this economic crisis.

OK, but what about a macro economic view? Well, John Lanchester in last weeks London Review of Books gives a wonderful primer on exactly how we find ourselves in this mess:

The complexity is such that even the people who know what they’re doing don’t always know what they’re doing. Derivatives are extensively used in arbitrage. That’s the name of investments which effectively bet both ways on the market, exploiting small differences in price to make what should be risk-free profits. (It’s what Leeson was supposed to be doing, exploiting tiny differences in the price of Nikkei 225 futures between the Osaka Securities Exchange, where trading was electronic, and the Singapore International Monetary Exchange, where it wasn’t. The gap in price would last only for a couple of seconds, and in that gap Barings would buy low and sell high – a guaranteed, risk-free profit.) The complexity of the mathematics involved in derivatives can’t be exaggerated. This was the reason John Meriwether, a famous bond trader, employed Myron Scholes – of the Scholes-Black equation – and the man with whom Scholes shared the 1997 Nobel Prize in Economics, Robert Merton, to be directors and cofounders of his new hedge fund Long-Term Capital Management. (A word on the term ‘hedge fund’: it is misleading. Hedge funds are pools of private capital, operating without the legal restrictions that affect other forms of collective investment. Many of them make big bets on the markets, using super-sophisticated rocket-sciencey investment techniques.) The idea was to use these big brains to create a highly leveraged, arbitraged, no-risk investment portfolio designed to profit whatever happened, whether the market went up, down, sideways or popped out for a cheese sandwich. LTCM quadrupled in value in its first four years, then imploded in the chaos that followed Russia’s default on its foreign-debt obligations in 1998. The fund had equity – that’s to say, actual money you could put your hands on – of $4.72 billion, which sounds pretty healthy, except that it was exposed, thanks to the miracles of borrowing, leverage and derivatives, to $1.25 trillion of risk. So if it went broke, LTCM would leave a $1.25 trillion hole in the global financial system. The big brains had made a classic mistake: they treated a very unlikely thing (the default and its consequences) as if it were impossible. As Keynes once observed (he who made himself and his college rich by spending half an hour a day in bed playing the stock market), there is nothing so disastrous as a rational policy in an irrational world.

The global economy has been run by statisticians and professional gamblers for far too long. Individuals who believe they can model a market flawlessly will lose money flawlessly. It is that simple. If someone comes across as too bright for their own good, they most likely are. We should not bail out these individuals or companies because it only rewards irresponsible behavior. It is the same as giving a drunk the money to get his vehicle out of the city pound. I do not believe markets need to be heavily regulated, but I do believe that there should be appropriate consequences for ridiculous risks.