Ur-Libor and Mutual-Fund Power

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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The guy who invented Libor.

One good way to charge for your product, if you can get away with it, is to charge your customer whatever it cost you to manufacture, plus a little something for profit. Here's an excerpt from Gavin Finch and Liam Vaughan's forthcoming Libor scandal book, "The Fix," describing the 1969 invention of Libor by Manufacturers Hanover banker Minos Zombanakis as a way to make floating-rate syndicated loans:

Zombanakis and his team came up with a solution: charging borrowers an interest rate recalculated every few months and funding the loan with a series of rolling deposits. The formula was simple. The banks in the syndicate would report their funding costs just ­before a loan-rollover date. The weighted average, rounded to the nearest eighth of a percentage point plus a spread for profit, became the price of the loan for the next period. Zombanakis called it the London interbank offered rate.

So the original point of Libor was as a way for banks to make guaranteed profits on their loans. (I mean, except for credit risk, etc.) All of the risks of the bank's funding costs -- not just the risks due to general interest-rate conditions, but even the risks due to the bank's own recklessness -- were passed on to the borrower. (Only on average -- if one bank was reckless and had to pay more than the others to borrow, it could only recoup a portion of that cost -- but still.)

Why wouldn't you expect the banks to game that? The way ur-Libor worked is: You had some banks, and they loaned a company some money, and every quarter the banks would go to the company and say "it cost us X to borrow, so please pay us X + 2 percent" or whatever. "Soon the rate was adopted by bankers outside the loan market who were looking for an ­elegant proxy for bank borrowing costs that was simple, fair, and appeared to be independent." But how on earth did it appear to be independent? It was the banks making up a number and then getting paid that number. Obviously they'd want to make up a higher number!

Anyway, then Libor became the reference rate for interest-rate swaps and everything else, even though it was still just banks making up some numbers:

“Even back then, it seemed to me that Libor was vulnerable to mischief,” says Robb, now chief executive officer at Christofferson Robb and a professor at ­Columbia. “It was ripe to explode. It was constructed in a shabby way that was fine for its original purpose, but when it became so dominant, it should have been strengthened and put on firmer foundations.”

One contrarian thing that I sometimes think about the big Libor scandal is that you can analyze it as a weird market. Some traders at some banks had interest-rate swaps that would profit if Libor was higher, so they pressured their Libor submitters to make up a higher Libor. Other traders at other banks had the other sides of those swaps, so they pressured their submitters to make up a lower Libor. The Libor rate that was ultimately set represented sort of a phantom clearing price for interest-rate derivatives; it may not have been a fair representation of banks' borrowing costs, but it was an imperfect approximate result of market forces. 

But notice that that only works if Libor is the reference rate for trillions of dollars of swaps with Libor-panel banks on both sides of them. If Libor was only used to set pricing on syndicated loans -- its original purpose -- then banks would only ever have an incentive to make it higher. The higher the Libor, the higher the rate the banks can charge. But once it was the underlying interest rate for all sorts of instruments, the incentives are not so obvious and one-way, and some banks might push against others and end up with a fair-ish result. In a way, Libor's shabby initial construction was better suited to its ultimate dominance than it was to its original purpose.

Maybe mutual funds aren't all bad.

We've talked a lot recently about the theory that index funds and other broadly diversified mutual funds might cause antitrust problems. The theory is that if Company A and Company B have a lot of the same shareholders, then those shareholders won't want Company A to do anything to hurt Company B, or vice versa. If Company A and Company B are competitors, then the shareholders won't want one of them to slash prices to gain market share: High industry-wide profits are what the shareholders want, and they're indifferent to which particular company earns them, so they won't want fierce competition.

A lot of people are skeptical about this theory, mainly because they don't believe that diversified institutional shareholders really influence companies in this way. Sure! But let's leave that aside for a minute. Let's assume that the theory is true and that there is some mechanism by which diversified shareholders push managers of Company A and Company B to cooperate with each other for their mutual good. If Company A and Company B are competitors, that is bad. 

But what if they're not? Here's a paper from Kayla Freeman at Indiana University about cross-ownership and vertical (customer/supplier) relationships:

In this study, I address whether common ownership (defined as the extent to which firms are held by the same institutional investors) in customer firms and supplier firms strengthens supply chain relationships. I find common ownership increases the longevity of customer-supplier relationships. These results are stronger in cases where theory predicts the trade relationships are more likely to be plagued by supply chain frictions.

I guess that is good? Freeman does "not directly address this question empirically," but notes that "theory and empirical findings from a host of prior studies provide strong evidence that customer-supplier collaboration is value-enhancing." Also:

If we make the simple assumption that the goal of mutual fund managers is to generate alpha in their fund portfolios, then we would not expect to see them effecting stronger vertical relationships if they are destroying value in their portfolios by doing so. Rather, showing a causal link between common ownership and vertical relationships suggests that the stronger ties must be economically beneficial to the owners of these companies.

I realize that people will still find this story a bit far-fetched. It's hard to imagine Vanguard Group showing up at the offices of a manufacturer and strong-arming it into buying parts from another company where Vanguard is a shareholder. The mechanism for all of this stuff still seems a bit vague.

But isn't it such a good story? It's a story about how all big public companies, in some approximate sense, approach being a single company, through the mechanism of diversified institutional investors. There is a set of things that are Good For Big Business as a whole, and each big business works to achieve those things, even if they're not in its individual self-interest, because the dominant shareholder class that owns all the big businesses subtly but inexorably imposes its will on them all. There is a secret group of Illuminati who control all of the world's big companies, and who coordinate those companies' activities. But it's not, like, six guys in a smoke-filled room. It's much more diffuse and abstract than that. You can never directly observe that group exercising its power; you can only catch glimpses of it in statistical analyses of data. But if you believe that it exists, the financial world is a more enchanted place.

Mnuchin!

Speaking of Illuminati, I said this two weeks ago:

Donald Trump's closing argument in this presidential campaign was a two-minute advertisement blaming America's problems on a conspiracy of global financiers like George Soros and Goldman's Lloyd Blankfein, so it seems fitting that the two leading candidates to be his Treasury Secretary are Steven Mnuchin and Wilbur Ross. Mnuchin is a former Goldman Sachs Group Inc. partner, used to work with Soros, and is in Skull and Bones. Ross was literally the president of a secret Wall Street fraternity that holds black-tie dinners where they perform in drag and make fun of the less fortunate. If you voted for Trump to kick the Illuminati out of Washington, this must be a disappointment.

Nothing much has changed, except that Ross will apparently be Trump's commerce secretary, and Mnuchin will apparently be Treasury secretary. What does Mnuchin's appointment mean? It's hard to say: Like so much of Trump's campaign and transition, Mnuchin is a blank slate for the projection of your hopes and fears. Here are his views, from an August profile by Max Abelson and Zachary Mider:

Mnuchin won’t say whether Goldman’s Hank Paulson was a good Treasury secretary. Asked about the Dodd-Frank financial regulation act, he says there are good and bad things about it, without elaborating. 

Andrew Ross Sorkin says that Mnuchin is expected to be "one of the adults in the administration," and quotes Henry Paulson calling him "an excellent choice." If there's one thing that you can tell about Mnuchin's views from his background, it's that he's a trader:

And for everyone on both coasts who still can’t believe Mnuchin has tied himself to Trump, he has an answer: “Nobody’s going to be like, ‘Well, why did he do this?’ if I end up in the administration.”

It feels like that could be a motto for the Trump administration generally. 

Elsewhere in Trump and economic policy: "Trump Notches a Win as Carrier Agrees to Keep 1,000 Jobs in U.S." Here at Bloomberg View, Tyler Cowen worries that Trump's focus on preventing jobs from moving to Mexico could lead to capital controls in which "every capital transfer decision would be subject to the arbitrary diktats of politicians and bureaucrats." And: "Bill Walton, Old Einhorn Enemy, Makes a Comeback With Trump Role." And: "Donald Trump, the First President of Our Post-Literate Age." And what do Wharton kids think about Trump?

Bridgewater.

Bridgewater Associates, the world's largest hedge fund, is pretty into Transcendental Meditation, but I find that just reading its press statements puts me in a meditative place. This is lovely:

Bridewater said in a statement: “We have policies to protect ourselves that are both legal and reached in agreement with the people who are affected by them and we are pleased to let the legal-regulatory system judge their merits. That has been done and we are pleased and respectful of the process.”

That soothing roll of nonsense syllables: It would make a great mantra. You know my theory is that Bridgewater is run by computers, and it does sound a little like the computers have been writing the statements. Anyway Bridgewater settled a National Labor Relations Board action over some of the confidentiality provisions in its employment agreements, but delightfully, most of the details of the settlement are confidential. Bridgewater's sense of whimsy is contagious, and even the NLRB apparently got caught up in it.

Blockchain blockchain blockchain.

Okay sure:

The UK’s Royal Mint is teaming up with the world’s biggest futures exchange operator to launch a new way to trade physical gold based on the technology behind the digital currency bitcoin.

The product, to be called Royal Mint Gold, or RMG, will launch in 2017, the mint said in a joint press release with Chicago-based exchange giant CME Group on Tuesday.

Each RMG will be a digital record certifying ownership of gold at a secure bullion vault run by The Royal Mint.

You know what else could be a digital record certifying ownership of gold at a secure bullion vault run by The Royal Mint? A list. The Royal Mint could have a list of people to whom it owes gold, and then when those people show up, it could give them the gold. And when you agree on a trade on the CME, instead of updating a distributed cryptographic ledger kept by multiple parties, the CME could just update The Royal Mint's list. Ah, but you see, what if people don't trust The Royal Mint to keep the list? The advantage of using a blockchain is that it avoids the need for a trusted intermediary: The record of ownership and transactions is kept, cryptographically, by all the participants in the market, rather than relying on a central counterparty to keep the record. Fine! But you know what else The Royal Mint keeps? The gold. If you don't trust The Royal Mint to keep the list of gold owners, why do you trust it to keep the gold?

Elsewhere in blockchain: "Has the blockchain hype finally peaked?" And elsewhere in physical gold, a man stole an 86-pound bucket of gold flakes worth $1.6 million off the back of an armored truck in Midtown Manhattan, and walked away very slowly.

People are worried about unicorns.

Is Uber a car service, or an app that connects independent car drivers with passengers? I actually think that this is a fundamentally uninteresting question, and all the passion expended on it leaves me a bit cold. Uber is a specific set of facts -- the app, the relationships, the nuanced power dynamics among the company and the drivers and the passengers -- and there is no deep reason to categorize those facts as all-app or all-service. But oh man is that not legal advice. Because it is an important legal question, boring though it is, and the European Court of Justice is now considering it, with potentially big consequences:

If the company is defined as a transportation service, it must comply with national laws that may restrict how Uber grows in Europe.

Yet if the judges rule the company is just an intermediary that connects drivers with passengers, legal experts say, Uber may gain greater freedom to offer more transportation, food delivery and other services to European consumers.

If you don't get too hung up on the categorization stuff, you might ask more useful policy questions like "is Uber good for people" or "is this the sort of society we want to have" or whatever. I suppose you can smuggle those questions into the service-or-app discussion too, but it always seems a bit fake. You're not going to find a magic proof that Uber drivers are really employees, or really contractors, or whatever, that will obviate all the bigger questions. 

Elsewhere here's Golden State Warriors player Andre Iguodala on what moving to the Enchanted Forest did for his investment strategy:

When I got to the Bay Area, one of the first things I did was reach out to those companies and the venture capital funds in Silicon Valley to learn and become more involved. I could have easily just let my money sit in savings, or invested in real estate, but that’s not where my passion is. Investing in startups and emerging tech stokes the same competitive urge that makes me good at my day job. 

People are not worried about bond market liquidity anymore, it's all better now, congratulations everyone!

Attentive readers may have noticed that, every day for at least the last year and a half, this newsletter has mentioned that "people are worried about bond market liquidity." Rain or shine, we get a little bond market liquidity, but I have to say that it's more shine than rain. When bond markets are serene, people are worried about bond market liquidity: They fear that, in a crunch, they won't be able to sell bonds, and the results will be a systemic crisis. But whenever there is a crunch, when bond prices move rapidly, people stop worrying about bond market liquidity. They are too busy selling their bonds to worry about being unable to sell their bonds.

There's been a crunch recently. Here's Bloomberg Gadfly's Lisa Abramowicz:

Traders seemed to do just fine this month despite a significant disruption in the status quo. After Donald Trump was elected as the next U.S. president on Nov. 8, traders ratcheted up their expectations of inflation and benchmark borrowing costs. Treasuries and government agency-backed bonds experienced their biggest monthly decline since 2004. Corporate bonds suffered their biggest losses since 2013. Investors suddenly priced in significantly higher inflation and interest rates.

But, as she points out, this bond rout occurred on high volumes, and with "a healthy two-sided market." Expectations changed, and people wanted to sell, and prices adjusted, and people bought. It looked ... kind of like a market? Sure it is no longer a market that is intermediated through huge dealer balance sheets, and there will be hiccups and volatility and maybe the odd run on a bond mutual fund. But the systemic disaster that people keep expecting keeps not arriving.

Abramowicz has been writing about bond market liquidity far longer than I have, and if she has concluded that we don't need to worry about bond market liquidity anymore, that is good enough for me.

Also I am super bored by it to be honest? I now declare this section non-mandatory. If people are actually worrying about bond market liquidity, I'll write about it. But I'm going to stop scraping Google for Maltese fund managers who might mention the word "liquidity." Bye!

Things happen.

RBS Fails Toughest-Ever BOE Stress Test, Boosts Capital Plan. Jes Staley’s contrarian bet on investment banking at Barclays. OPEC Ministers Say a Deal Is Close as Meeting on Oil Cuts Begins. China capital curbs reflect buyer’s remorse over market reforms. Company Earnings Show Strength as U.S. Growth Picks Up. Closed-end fund activism. Goldman Said to Prepare Volcker Defense for $250 Million Trader. Afghan mortgages. Number of ‘problem’ banks at seven-year low. U.S. probes hit defunct energy company linked to Platinum Partners. A New Strategy for Shareholder Activism: Engagement. Fintech Founder Pleads Guilty to Making Illegal Campaign Contributions. "The book does not have an acknowledgments section." Haggis might be legal soon. "It's probably a good time to review Balk's Three Laws." Trading nuns. Finance for kids. Justin Timberlake's 'Can't Stop the Feeling' named worst song of 2016. 

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net