The Bear’s Lair: Don’t blame the traders for everything

The trader Tom Hayes spent last week at Southwark Crown Court, accused of manipulating the LIBOR market. He appears distinctly unlucky; his manipulation was only profitable because of the grotesque bloating of the interest rate swaps market, which rendered inadequate a LIBOR mechanism that was solid when devised in 1985. Traders do what they do, but cannot be expected to take responsibility for the market distortions caused by funny money and rampant uncontrolled technology. That responsibility lies higher in the food chain, in banks, central banks and governments. Jail sentences would be much better imposed on the true causes of the trouble.

The London interbank market grew up after 1957, first as a result of the Soviet Union’s desire to hold dollar deposits outside the United States, then as a result of some especially foolish U.S. regulations imposed on 1963 on deposit interest rates payable. By the end of the 1960s, a modest international loan market had grown up using these “Eurodollar” deposits. Since inflation was high and U.S. banks were already getting in trouble domestically through medium-term lending at fixed rates while deposit rates rose, a market grew up in medium term loans whose interest rate varied every 3 or 6 months according to the prevailing level of deposit rates. Since it was clearly impossible for borrowers to agree to a rate setting mechanism involving only the lending bank, a system grew up whereby quotes were obtained from 3-4 “reference banks,” of prime quality operating in the London market, where the Eurodollar market was centered.

This system worked very well through the 1970s and 1980s, even as the market exploded in size. In 1985 the British Bankers Association formalized the system, so that a central LIBOR was set at 11.00 each business day, according to the quotations of 18 leading banks, of which the BBA threw out the four highest and four lowest. As a system for setting the interest rates on loans, this was both efficient and of a high level of integrity; any individual bank could affect the LIBOR quotation by only a basis point (0.01%) or even less, since if it set a rate markedly higher than the consensus its rate would be eliminated by the BBA.

I designed and helped to set up a parallel system for the Croatian kuna ZIBOR in Zagreb in 1997; it has worked pretty well to this day, even though one or two of our reference banks were known to be effectively insolvent and did not participate significantly in the interbank market.

The reason why LIBOR worked pretty well in London in the 1980s and ZIBOR worked in Zagreb from 1997 was that the potential rewards from cheating were modest. One basis point on the 3-month interest rate for even $1 billion of loans (about the most that’s likely to be rolling over for 3 months on a single day by a single bank) is $25,000. It’s not worth the effort for a trader to go through the trouble and risk of manipulating LIBOR to gain $25,000 for his bank; it’s not a significant enough part of his profits budget, especially as on most days a single bank can’t affect the LIBOR quote by even a single basis point.

The invention of interest rate swaps changed all that. Now, with more than $400 trillion of interest rate swaps outstanding, roughly $2 trillion of them roll over each day, and so a house with a large swaps market share can easily have $200 billion rolling over on a single day. If the principal amount rolling over is $200 billion, the profit from fudging LIBOR by 1 basis point is $5 million – an amount that represents a substantial element in any trader’s potential revenue target for the year. The temptation is irresistible – as Hayes told the Serious Fraud Office in 2012 (according to the FT): “Not even Mother Teresa wouldn’t manipulate LIBOR if she was trading it.”

Given the temptations, it’s not surprising Hayes and other traders rigged LIBOR; it would have been astonishing had they not done so. However the banking system, in piling $400 trillion of interest rates swaps into a rate setting mechanism meant to accommodate only a thousandth of that amount, was like the dozy dowager wearing her priceless pearls down the Bowery. Traders, like Bowery bums, do what they do and are not especially cerebral about why they do it. It behooves the more thoughtful and responsible members of society, in bank upper managements and elsewhere, to structure the system so as not to put temptation in their way.

In other areas, when inspected closely, the traders themselves appear largely blameless, merely pursing their natural activity in a system whose structure and incentives are perverted. In housing finance, for example, the structured finance activities of Goldman Sachs’ “Fabulous Fab” Tourre, found guilty of civil fraud in 2013, were only possible because of the housing finance bubble caused by misguided government directives and mistaken monetary policies. Constructing collateralized debt obligations, let alone second and third order CDOs, out of subprime mortgages would never have occurred if government had not forced banks to create poorly-conceived subprime mortgages and insane monetary policy had not led foolish borrowers to think that taking on subprime mortgage obligations was sound personal finance strategy.

Similarly, the multi-billion dollar losses suffered by AIG in the credit default swap market were the result both of the housing finance crash and of the perverted risk management in the Wall Street houses, which valued CDS as if they were normal “Gaussian” risks, with only a modest probability of producing gigantic losses. In reality, CDS were pathological, with risk profiles far outside the norms of bonds and stocks. They should be (and still are not) treated by risk management systems like the loans they represent, with full 100% allocation of the default risk involved against banks’ capital. But whatever mistakes were made in the CDS market, it was not traders who made them; they were simply gravitating to a new product of exceptional profit potential, using trading limits that were far too large because their banks did not understand (or deliberately ignored) the risks involved.

The systems imposed from above that cause traders to behave “badly” (just by reacting naturally to the economic incentives placed before them) are multifarious. The most important is monetary policy. If you impose negative real interest rates for seven years, people are going to borrow; if before that in 2001-07, you allow mortgage rates to be close to or below the rate of inflation, you are going to get a mountain of dodgy housing finance. The fault is not in the hedge fund guys, traders or mortgage brokers who operate within your perverse incentives, it is in the people who created such an economically bizarre environment.

Similarly, if you create a risk management system that systematically underprices the more perverse and exotic risks, you are going to get quants inventing ever more perverse and exotic risks and traders trading them. The fault here is not on the quants and traders, junior individuals stretching for the next bonus in a natural fashion. Instead it lies with the senior members of bank management, ignoring the risks incurred by their juniors in the hope of reaping profits from their stock options. It is also on the regulators, for allowing banks to use such inadequate risk management systems and for allowing bank managements to be so excessively rewarded based on short term profits.

The responsibility lies also on the accountants for allowing companies to treat stock options as a loophole, through which their top management could be overpaid without shareholders being properly informed of the options’ cost. The accountants are also responsible for the “mark to market” rules, which are hugely dangerous and pro-cyclical and caused the bankruptcy of Lehman Brothers by destroying market confidence in it. The fault lies also with the SEC, even under the sainted Ronald Reagan, which in November 1982 passed Rule 10b-18, which allowed companies to repurchase their shares without a full tender offer, and gave them safe harbor against the stock manipulation prosecutions and lawsuits that would previously resulted from such activity.

(SEC Chairman John Shad, who by this regulation destroyed the ethics of business management for decades to come, in a fit of contrition established in 1987 a Chair of Business Ethics at Harvard Business School, accompanied by a compulsory course to be taken by all students. It was from the institution of this course that the true collapse in ethical standards of HBS graduates can be dated; like all good B-School students, they learned from the course how to work the loopholes in the system.)

In general, regulations devised by government bodies, accounting bureaucracies and the top management of large corporations are self-serving and may produce adverse effects far in excess of the problems they attempt to solve. The traders whose immediate activities produce the adverse effects are however not to be blamed, banned from the business, socially ostracized and jailed. Nor should the shareholders of the institutions be penalized; they did nothing to cause the problems, nor knew anything about them until years afterwards. Instead their bosses, accountants, regulators and politicians, who designed the systems that have so monstrously failed, are the ones who should receive jail sentences and billion dollar fines.

That would however require a level of self-criticism in the top levels of business, finance and government that is altogether missing.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)