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Libor Crisis Chronology. In the spring of 2007, Bear Stearns went bankrupt due to catastrophic losses in their mortgage backed securities portfolio when AAA rated mortgage paper “failed”. Up until that time, AAA rated commercial paper had NEVER failed.
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Libor Crisis Chronology • In the spring of 2007, Bear Stearns went bankrupt due to catastrophic losses in their mortgage backed securities portfolio when AAA rated mortgage paper “failed”. • Up until that time, AAA rated commercial paper had NEVER failed. • As a result of AAA rated paper “failing” – by Aug. 2007 credit markets seized up because banks refused to extend credit – even to one another.
What is Libor? • The term Libor stands for London Interbank Offered Rate. Libor rates are officially set in London each morning by a group of reference banks appointed by the British Bankers Association. Libor rates serve as benchmarks, or reference rates from which commercial loans are set. Eurodollar futures serve as symbiotic proxy for 3 month for Libor [the cost of a 3 month time deposit].
When Libor was first observed as being dis-functional Timeframe: Q3/2007
TED spread is the difference in yield between 3 month Eurodollar Future and 3 Month T-bill in basis points. The Eurodollar Future is a proxy for Libor.
The rush into U.S. T-Bills was “sold to the world as a “flight to quality” trade
So what really happened? • In Q3/2007 the < 1 year component of J.P. Morgan’s Interest Rate derivatives book grew from 25.27 Trillion in notional to 32.81 Trillion in notional – a gain of more than 7.5 Trillion in one quarter. In Q4/2007 – the same component of Morgan’s Interest Rate derivatives book “recoiled” back to 24.65 Trillion.
Additionally……. • When we look at the same Quarterly Derivatives reports at table 1: We can retrieve even more evidence as to what Product Morgan was trading to bulge their Interest Rate Derivatives book by 7.5 Trillion in Q3/2007. • The “bulge” was in their OTC [over the counter] Swap book – which grew from 50.88 Trillion in Q2/2007 to 61.53 Trillion in Q3/2007 before falling back to 53.84 Trillion in Q4.2007. • So the “bulk” of the add was OTC Swaps that were < 1 year – which only stayed on Morgan’s books for 3 months. • THERE IS ONLY 1 INSTRUMENT IN THE WORLD THAT FITS THAT DESCRIPTION.
So what exactly is a FRA? • FRA [Forward Rate Agreements] are OTC Swap instruments which are “bets” – between counterparties – as to what Libor rates will be in the future. Buying FRA’s is sometimes referred to as “synthetic borrowing” and selling FRA’s is sometimes referred to as “synthetic lending”. • Because FRA’s are “bets” they require that buyer and seller of the product EACH have credit lines for one-another – because – in theory – one never knows “who” is going to win the bet. • The natural hedges for U.S. Dollar FRA trades are either Eurodollar futures or U.S. Gov’t T-bills.
Remember back in Q3/2007 there was a credit crisis…….. • In Q3/2007 the world was gripped by a CREDIT CRISIS where banks would not even lend to one another on an overnight basis. This is a matter of highly documented historical FACT. • So how did J.P. Morgan mange to do “TRILLIONS” of dollars worth of FRA’s [which require CREDIT] when NO BANKS WERE EXTENDING CREDIT???? • Perhaps a better question is, WHO did J.P. Morgan do TRILLIONS of FRA’s with when banking counterparties were NOT EXTENDING CREDIT, hence, NOT TRADING???
J.P. Morgan’s counterparty was NOT A BANK • J.P. Morgan was a PURCHASER of short dated FRA’s at yields LESS THAN the those of the short dated T-bills they purchased to hedge and lock in profits. • This is why, initially, 3 month T-bill rates plummeted 200+ basis points in days while Eurodollar futures rates stood still [reflecting banks’ unwillingness to lend or extend credit]. • This is what “blew out” the TED spread and made Libor appear to be “broken”.
The other side of Morgan’s trades could only have been one counterparty • Given that the world was gripped in a credit crisis where NO CREDIT WAS AVAILABLE and given that J.P. Morgan was “induced” to trade and extend massive amounts of credit and purchase UNTHINKABLE amounts of U.S. Government T-bills at ever decreasing yields – we can conclude that J.P. Morgan was trading with the U.S. Treasury itself. J.P. Morgan executed TRILLIONS of dollars worth of FRA trades with the U.S. Treasury’s Exchange Stabilization Fund [ESF].
The Libor Crisis was Made in America • Any notion that the Libor crisis was the fault of Euro-centric banks is misinformation and a fabrication. • The Libor crisis came about when banks – acting prudently – stopped buying commercial paper or extending credit - arising from the FAILURE OF TRIPLE A RATED U.S. Mortgage paper. • When the credit markets “FROZE” – the U.S. Treasury / Fed PANICKED and forced rates to zero to try to “thaw” the freeze.
Blame the Ratings Agencies • If “blame” for the Libor crisis is to be put anywhere – it should be on the U.S. ratings agencies that rated toxic sub-prime mortgage paper as AAA. • It was their greed and incompetence – working hand-in-hand with TOO BIG TO FAIL U.S. BANKS that created the problem. • The U.S. Treasury - using the New York Fed as their “broker” – engaged in “electro shock therapy” for the global credit markets. J.P. Morgan was FULLY aware that rates were going to ZERO and were categorically trading with insider information, heck, they were IMPLEMENTING U.S. Monetary policy off their trading desk. • This is the kind of “massaging” ALL OF OUR CAPITAL MARKETS now receive on a regular basis by U.S. Monetary Authorities.
