Category Archives: Banking

Good Thing? US Treasury Curve Flattens To Zero As Unemployment Falls To Lowest Level Since 1969

Good thing! US unemployment has fallen to its lowest level since the 1960s.

The US Treasury 10-year – 3-month yield curve has flattened to zero as unemployment hits its 50 year low.

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Is this signaling the end of a business cycle? Or is it signaling the excesses of central banking?

We are seeing turbulence in the US yield curve given the many economic uncertainties around the globe, like Brexit, China trade, etc.

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At least devaluation of the US dollar Purchasing Power has slowed.

https://confoundedinterestnet.files.wordpress.com/2019/05/fed1913.png

Source: Confounded Interest

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Globalist Utopia: Negative Rates Are Coming, Whether You Like It Or Not

There is nothing that a human mind can’t conceive. It can shoot for the stars or dive in the ocean which twinkles in the shadows of stars and ascend back with sparkling mind bearing uncanny ambition, only to float contended.  

https://www.zerohedge.com/s3/files/inline-images/the-wizard-of-oz.jpg?itok=6D0neJ7E(by Ritesh Jain via WorldOutOfWhack.com)

Today, we live in fear of losing wealth, we worry what economic consequences would do to our cash, we look through a microscope and scrutinize every word, every policy, every regulation or find something to put above ‘every’ and list out the glaring negatives with a slight trace of approval. If only one could notice the lens of the microscope, would then one could tell reel and real apart.

Such is the case of negative interest rates. It is dealt differently by different flock of loaded individuals, generally in ways which would not only prevent losses but essentially gain cash. This flock stands on one side of the transaction contemplating means to win regardless of the loss that still deliberating other doomed flock endures. Well, this is how the world works. It is a Bernoulli trial. But there exists a splash of humble wit folks floating beneath the starry sky delighted by the victory of each one and beaten down none.

Theory? Without thinking too much, negative rates indicate that the economy is unable to generate sufficient income to service its debt. Almost always, all roads leads us back to debt sustainability levels. In order for an economic system to reduce debt, it requires growth or inflation or currency devaluation. For an economic system to exercise one of the two (growth not included), capital transfer is to be facilitated. This capital movement in negative rates environment is from the savers to the borrowers. Your invested value, the money you gave to borrowers would have a value lower than the face value. Barbaric! Savers should be the winners not the borrowers!

So each flock as per their liking would act in a way that makes them the gaining side. In real world scenario, one flock could be investors who when yields falls even deeper into negative territory scoop a profit through capital gain. Flock of foreign investors may try to earn through currency appreciation. Another flock would focus on real rates even though they are negative as that would preserve their capital under deflationary conditions when nominal yields would decrease their capital. Who would want that!

Investopedia gave an example, “In 2014, the European Central Bank (ECB) instituted a negative interest rate that only applied to bank deposits intended to prevent the Eurozone from falling into a deflationary spiral.”

Let’s recall a real practical example. The case of Switzerland.

Paul Meggyesi of JP Morgan said, “The defacto negative interest rate regime lasted until October 1973. The negative interest rate was re-introduced in November 1973 at 3% per quarter and then increased to 10% per quarter in February 1978. All though this period capital inflows were being sustained by the global monetary turmoil/inflation that characterized the first years of floating exchange rates, not to mention the SNB’s singular focus on promoting monetary and price stability through money supply targeting. Ultimately the SNB abandoned these purely technical attempts to curb capital inflows and embraced a much more effective policy of currency debasement, namely it abandoned money supply targeting in favor of an explicit exchange rate target that required huge amounts of unsterilized intervention, money supply expansion and ultimately inflation. (Suffice to say this policy lasted only until 1982, when the Swiss realized that inflation was too high a price to pay for a weak currency).”

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He continued “Negative interest rates will only deter capital inflows if they are sufficiently large to offset the capital gain an investor expects to earn through capital appreciation. CHF rose by 8% in nominal and real terms in 1972-1973. Appreciation in 1973 – 1978 was 62% in nominal and 29% in real terms.”

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In fact, during global financial crisis many central banks reduced their policy interest rates to zero. A decade later, today, still many countries are recovering and have kept interest rates low. Severe recessions in the past have required 3 – 6 percent point cuts in interest rates to revive the economy. If any crisis were to happen today, only a few countries could respond to the monetary policy. For countries with already prevailing low or negative interest rates, this would be a catastrophe.

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Today, around $10 trillion of bonds are trading at negative yields mainly in Europe and Japan as per Bloomberg.

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Poisons have antidotes, and sometimes one need to gulp down the poison to witness the mystique surrounding the life and glide with accidental possibilities, the possibilities which one wouldn’t seek if they remain wary of novel minted cure. 

Here enters a splash of humble wit folks! They want a win – win. So these folks came up with an idea, an idea with legal and operational complication but they have swamped themselves with research to find ways to not stumble in future and yes they do have a long way to go but we have a start. These folks are our very adored IMF Staff.!

They are exploring an option that would help central banks make ‘deeply negative interest rates’ feasible option.

Excerpt from their article ‘Cashing In: How to make Negative Interest Rates Work’:

“In a cashless world, there would be no lower bound on interest rates. A central bank could reduce the policy rate from, say, 2 percent to minus 4 percent to counter a severe recession. When cash is available, however, cutting rates significantly into negative territory becomes impossible.”

“…Cash has the same purchasing power as bank deposits, but at zero nominal interest. Moreover, it can be obtained in unlimited quantities in exchange for bank money. Therefore, instead of paying negative interest, one can simply hold cash at zero interest. Cash is a free option on zero interest, and acts as an interest rate floor.

Because of this floor, central banks have resorted to unconventional monetary policy measures. The euro area, Switzerland, Denmark, Sweden, and other economies have allowed interest rates to go slightly below zero, which has been possible because taking out cash in large quantities is inconvenient and costly (for example, storage and insurance fees). These policies have helped boost demand, but they cannot fully make up for lost policy space when interest rates are very low.”

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“… in a recent IMF staff study and previous research, we examine a proposal for central banks to make cash as costly as bank deposits with negative interest rates, thereby making deeply negative interest rates feasible while preserving the role of cash.

The proposal is for a central bank to divide the monetary base into two separate local currencies—cash and electronic money (e-money).

E-money would be issued only electronically and would pay the policy rate of interest, and cash would have an exchange rate—the conversion rate—against e-money. This conversion rate is key to the proposal. When setting a negative interest rate on e-money, the central bank would let the conversion rate of cash in terms of e-money depreciate at the same rate as the negative interest rate on e-money. The value of cash would thereby fall in terms of e-money.

To illustrate, suppose your bank announced a negative 3 percent interest rate on your bank deposit of 100 dollars today. Suppose also that the central bank announced that cash-dollars would now become a separate currency that would depreciate against e-dollars by 3 percent per year. The conversion rate of cash-dollars into e-dollars would hence change from 1 to 0.97 over the year. After a year, there would be 97 e-dollars left in your bank account. If you instead took out 100 cash-dollars today and kept it safe at home for a year, exchanging it into e-money after that year would also yield 97 e-dollars.

At the same time, shops would start advertising prices in e-money and cash separately, just as shops in some small open economies already advertise prices both in domestic and in bordering foreign currencies. Cash would thereby be losing value both in terms of goods and in terms of e-money, and there would be no benefit to holding cash relative to bank deposits. This dual local currency system would allow the central bank to implement as negative an interest rate as necessary for countering a recession, without triggering any large-scale substitutions into cash.”

Negative rates are coming whether we like it or not. There is only so much growth we can get in steady state among rising debt levels. The only hurdle to implementing negative rates is currency in circulation and that’s why more and more countries are trying to outlaw cash. Interesting and profitable times ahead for those who understand the brave new world.

Source: ZeroHedge

70% Of Consumers With Credit Cards Say They Can’t Pay It Off This Year

Zerohedge readers who follow our monthly consumer credit updates already knew, aggregate household debt balances jumped in 4Q18. As of late December, total household indebtedness was at a staggering $13.54 trillion, $32 billion higher than 3Q18.

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More troubling is that 37 million Americans had a 90-day delinquent strike added to their credit report last quarter, an increase of two million from the fourth quarter of 2017. These 37 million delinquent accounts held roughly $68 billion in debt, or roughly the market cap of BlackRock, Inc.

* * *

New evidence this week points to a further deterioration in consumer creditworthiness.

To understand the American credit card debt crisis, real estate data company Clever surveyed 1,000 credit card users earlier this month.

Using Consumer Financial Protection credit card complaint data and other forms of consumer metrics, the company was able to gain tremendous insight into the average American’s purchasing habits, dependence on credit cards, and feelings about their debt situation.

The survey found that 47% of Americans have a monthly balance on their credit card. About 30% of respondents with credit card debt believe they’ll extinguish the debt this year, leading many of the respondents stuck in an endless debt cycle.

Fifty-six percent of the respondents say they’ve had credit card debt for more than a year. About 20% estimate their debt will be paid off by 2022, while 8% were unsure about a timeline.

“It’s a big issue,” Ted Rossman, credit industry expert for CreditCards.com, tells CNBC. With credit card APR soaring to about 17.64%, a new high, the interest accrued on monthly balances can quickly add up and trap unsuspecting consumers with insurmountable debt.

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The U.S. recovery has been the slowest since WWII. Consumers have been stuck in the gig-economy with low wage and skill jobs. Their wages have not been able to outpace rapid inflation in groceries and rent. So many have resorted to credit cards to supplement their daily expenses. This is especially prevalent with lower-income families, defined here as those earning less than $50,000 a year. Buying groceries” ranked as the top expense that racked up people’s balances, the survey said.

About 28% of respondents say they’re fully dependent on credit cards to pay rent and utilities.

Emergency expenses were also a major contributor to credit card balances. About 30% cite medical bills and 40% say automobile repairs have moved their balances higher.

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Surprisingly, there is some good news. Sixty-two percent of millennials indicate they pay their balance every month. That’s compared to just 48% of Generation X and Baby Boomers.

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Credit cards are an integral part of developing credit and proving creditworthiness. Multiple reports show the consumer is on the cusp of a dangerous deleveraging, an ominous sign that the credit cycle has likely turned. Winter is here.

Source: ZeroHedge

“Recap & Release” – Trump Unveils Plan To End Govt Control Of Fannie, Freddie

After months (or years) of on-again, off-again headlines, President Trump is expected to sign a memo on an overhaul of Fannie Mae and Freddie Mac this afternoon, kick-starting a lengthy process that could lead to the mortgage giants being freed from federal control.

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The White House has been promising to release a plan for weeks, and its proposal would be the culmination of months of meetings between administration officials on what to do about Fannie and Freddie.

Bloomberg reports that while Treasury Secretary Steven Mnuchin has said it’s a priority to return the companies to the private market, such a dramatic shift probably won’t happen anytime soon.

In its memo, the White House sets out a broad set of recommendations for Treasury and HUD, such as increasing competition for Fannie and Freddie and protecting taxpayers from losses.

The memo itself has a worryingly familiar title (anyone else thinking 2007 housing bubble?):

President Donald J. Trump Is Reforming the Housing Finance System to Help Americans Who Want to Buy a Home

“We’re lifting up forgotten communities, creating exciting new opportunities, and helping every American find their path to the American Dream – the dream of a great job, a safe home, and a better life for their children.”

President Donald J. Trump

REFORMING THE HOUSING FINANCE SYSTEM: The United States housing finance system is in need of reform to help Americans who want to buy a home.

  • Today, the President Donald J. Trump is signing a Presidential memorandum initiating overdue reform of the housing finance system.
  • During the financial crisis, Fannie Mae and Freddie Mac suffered significant losses and were bailed out by the Federal Government with billions of taxpayer dollars.
    • Fannie Mae and Freddie Mac have been in conservatorship since September 2008.
  • In the decade since the financial crisis, there has been no comprehensive reform of the housing finance system despite the need for it, leaving taxpayers exposed to future bailouts.
    • Fannie Mae and Freddie Mac have grown in size and scope and face no competition from the private sector.
    • The Department of Housing and Urban Development’s (HUD) housing programs are exposed to high levels of risk and rely on outdated business processes and systems.

PROMOTING COMPETITION AND PROTECTING TAXPAYERS: The Trump Administration will work to promote competition in the housing finance market and protect taxpayer dollars.

  • The President is directing relevant agencies to develop a reform plan for the housing finance system. These reforms will aim to:
    • End the conservatorship of Fannie Mae and Freddie Mac and improve regulatory oversight over them.
    • Promote competition in the housing finance market and create a system that encourages sustainable homeownership and protects taxpayers against bailouts.
  • The President is directing the Secretary of the Treasury and the Secretary of Housing and Urban Development to craft administrative and legislative options for housing finance reform.
    • Treasury will prepare a reform plan for Fannie Mae and Freddie Mac.
    • HUD will prepare a reform plan for the housing finance agencies it oversees.
  • The Presidential memorandum calls for reform plans to be submitted to the President for approval as soon as practicable.
  • Critically, the Administration wants to work with Congress to achieve comprehensive reform that improves our housing finance system.

HELPING PEOPLE ACHIEVE THE AMERICAN DREAM: These reforms will help more Americans fulfill their goal of buying a home.

  • President Trump is working to improve Americans’ access to sustainable home mortgages.
  • The Presidential memorandum aims to preserve the 30-year fixed-rate mortgage.
  • The Administration is committed to enabling Americans to access Federal housing programs that help finance the purchase of their first home.
  • Sustainable homeownership is the benchmark of success for comprehensive reforms to Government housing programs.

*  *  *

Because what Americans need is more debt and more leverage at a time when home prices are at record highs and rolling over.

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Hedge funds that own Fannie and Freddie shares have long called on policy makers to let the companies build up their capital buffers and then be released from government control.

It’s unclear whether the White House would be willing to take such a significant step without first letting lawmakers take another stab at overhauling the companies.

But not everyone is excited about the recapitalizing Fannie Mae and Freddie Mac. Edward DeMarco, president of the Housing Policy Council, warned that releasing them from conservatorship would do nothing to fix the mortgage giants’ charters or alter their implied government guarantee:

“I’m not sure what is good about recap and release,” DeMarco, a former acting director of the Federal Housing Finance Agency, said in a phone interview.

DeMarco also noted that the government stepped in to save the companies in 2008, and they continue to operate with virtually no capital. On Tuesday, DeMarco told the Senate, during the first of two hearings on the housing finance system that “recap and release should not even be on the table.”

But shareholders in the firms were excitedly buying… once again.

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Deciding the fate of Fannie and Freddie, which stand behind about $5 trillion of home loans, remains the biggest outstanding issue from the 2008 financial crisis.

Source: ZeroHedge

Under “Basel III” Rules Gold Becomes Money Again

In 2018, central banks added nearly 23 million ounces of gold, up 74% from 2017. This is the highest annual purchase rate increase since 1971, and the second-highest rate in history. Russia was the biggest buyer. And not surprisingly, the lion’s share of gold is flowing into central banks of countries that are in the sights of America’s killing machine—the Military Industrial Complex that Eisenhower warned us about in 1958.

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The Bank for International Settlements (BIS), located in Basal, Switzerland, is often referred to as the central bankers’ bank. Related to this issue of central bank hoarding of gold is the fact that on March 29 the BIS will permit central banks to count the physical gold it holds (marked to market) as a reserve asset just the same as it allows cash and sovereign debt instruments to be counted.

There has been a long-term view that China and other nations dishoarding dollars in favor of gold have been quite happy about western banks trashing the gold price through the synthetic paper markets. But one has to wonder if that might not change, once physical gold is marked to market for the sake of enlarging bank balance sheets.

This also raises the question with regard to how much gold the U.S. actually holds as opposed to what it claims to hold. James Sinclair has always argued that the only way the world can overcome the debt that is strangling the global economy is to remonetize gold on the balance sheets of central banks at a price in many thousands of dollars higher. This would mean a major change in the global monetary system away from the dollar, as China has been pushing for the last decade or so.

If banks own and possess gold bullion, they can use that asset as equity and thus this will enable them to print more money. It may be no coincidence that as March 29th has been approaching banks around the world have been buying huge amounts of physical gold and taking delivery. For the first time in 50 years, central banks bought over 640 tons of gold bars last year, almost twice as much as in 2017 and the highest level raised since 1971, when President Nixon closed the gold window and forced the world onto a floating rate currency system.

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But as Chris Powell of GATA noted, that in itself is not news. The move toward making gold equal to cash and bonds was anticipated several years ago. However, what is news is the realization by a major Italian Newspaper, II Sole/24 Ore, that “synthetic gold,” or “paper gold,” has been used to suppress the price of gold, thus enabling countries and their central banks to continue to buy gold and build up their reserves at lower and lower prices as massive amounts of artificially-created “synthetic gold” triggers layer upon layer of artificially lower priced gold as unaware private investors panic out of their positions.

The paper concludes that,

“In recent years, but especially in 2018, a jump in the price of gold would have been the normal order of things. On the contrary, gold closed last year with a 7-percent downturn and a negative financial return. How do you explain this? While the central banks raided “real” gold bars behind the scenes, they pushed and coordinated the offer of hundreds of tons of “synthetic gold” on the London and New York exchanges, where 90 percent of the trading of metals takes place. The excess supply of gold derivatives obviously served to knock down the price of gold, forcing investors to liquidate positions to limit large losses accumulated on futures. Thus, the more gold futures prices fell, the more investors sold “synthetic gold,” triggering bearish spirals exploited by central banks to buy physical gold at ever-lower prices”.

The only way governments can manage the levels of debt that threaten the financial survival of the Western world is to inflate (debase) their currencies. The ability to count gold as a reserve from which banks can create monetary inflation is not only to allow gold to become a reserve on the balance sheet of banks but to have a much, much higher, gold price to build up equity in line with the massive debt in the system.

Source: ZeroHedge

AOC: Wells Fargo ‘Involved’ In Caging Children; Thinks Banks Should Assume Borrowers’ Liabilities

More than two years after Wells Fargo & Co. erupted into scandals, Chief Executive Officer Tim Sloan returned to Capitol Hill to lay out his efforts to clean up the mess. The bank has apparently made little progress in winning over lawmakers.

However, all eyes were on Rep. Alexandria Ocasio-Cortez (D-NY) after she suggested Wells Fargo was “involved” in the caging of migrant children because the bank used to finance private prison companies CoreCivic and Geo Group during congressinal hearing.

It was a brilliant distraction…

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“Mr. Sloan, why was the bank involved in the caging of children and financing the caging of children to begin with?” the freshman House Democrat and economics major asked Wells Fargo CEO Timothy Sloan. 

“Uh, I don’t know how to answer that question because we weren’t,” Sloan replied. 

“Uh, so in finance — you, you were financing and involved in financing of debt of CoreCivic and Geo Group, correct?” she shot back. 

To which Sloan replied: “For a period of time, we were involved in financing one of the firms — we’re not anymore and the other. I’m not familiar with the specific assertion that you’re making, but we weren’t directly involved in that.”

“OK, so these companies run private detention facilities run by ICE, which is involved in caging children, but I’ll move on,” AOC retorted.

Of note, Wells Fargo was prominently featured in a November 2016 report along with nine other banks for lending CoreCivic and GEO Group $444 million and $450 million respectively during the Obama administration – the same period of time during which a a photo of caged children misattributed to the Trump administration was taken. 

Wells Fargo and other banks have decided to reevaluate their lending activities to private prisons amid controversy over the Trump administration’s immigration policies. 

Ultimate liability

AOC then shifted gears, asking Sloan if Wells Fargo should be involved in paying for environmental cleanup if a bank-financed oil project such as the Dakota Pipeline were to leak

“So hypothetically, if there was a leak from the Dakota Access Pipeline, why shouldn’t Wells Fargo pay for the cleanup of it, since it paid for the construction of the pipeline itself?” asked AOC – suggesting that the pipeline is “widely seen to be environmentally unstable.” 

Sloan looked a bit puzzled, replying: “Again the reason we were one of the 17 or 19 banks that financed that is because our team reviewed the environmental impact and we concluded that it was a risk that we were willing to take.” 

The responses to AOC’s line of questioning have been entertaining to say the least.  

Source: ZeroHedge

***

Review/Summary of The Brains Behind AOC Alexandria Ocasio-Cortez

Bond Illiquidity, LIBOR and You

Summary
  • A letter to the Alternative Reference Rates Committee (ARRC) from the Secured Finance Industry Group (SFIG) put an end to the fiction that major financial institutions support SOFR.
  • Financial institutions are justly concerned that SOFR could fatally squeeze bank margins in a crisis.
  • Nevertheless, other proposed alternatives, such as the changes to LIBOR proposed by Intercontinental Exchange (ICE), do not fit the regulators’ requirement that the replacement be determined by liquid market transactions prices.
  • Regulators cannot introduce a new financial instrument. LIBOR’s replacement must be the result of private sector innovation.

(Kurt Dew) A recent Secured Finance Industry Group (SFIG) comment letter is SFIG’s response to a request for comment by the Alternative Reference Rates Committee (ARRC) – a Fed-appointed committee of bankers tasked to solve the LIBOR problem. The Fed’s ARRC creation was an embarrassingly transparent attempt by the regulators to co-opt industry objections to their LIBOR replacement. ARRC proposes to replace LIBOR by the Secured Overnight Financing Rate (SOFR) – a Fed-created version of the overnight repurchase agreement rate. The SFIG comment details the objections of financial institutions to SOFR. Importantly, SFIG serves as chair of ARRC. The critical comment letter is thus the final blow to the regulators’ failed effort to gain the appearance of financial institution support for SOFR.

However, more importantly, neither financial institutions nor their regulators have a clear plan to resolve the need to replace LIBOR. If replacing LIBOR were not such a critical matter, the Byzantine machinations of the bank regulators and financial institutions around SOFR would be amusing. However, the pricing of tens of trillions in debt instruments and hundreds of trillions in derivative instruments depends on a smooth transition to some reference rate other than LIBOR. I contend that this enormous magnitude is a low estimate of the financial market assets at risk due to poorly governed debt markets.

Financial markets’ failure to solve the LIBOR replacement problem is the result of a misunderstanding of the reasons for the LIBOR problem. Understanding of LIBOR suffers from journalistic misdirection, on one hand, and a misunderstanding of the root problem that the LIBOR brouhaha exemplifies, on the other.

The failure of LIBOR is a market structure failure. However, the financial press bills LIBOR’s failure mistakenly as a failure of ethics among bankers. Recorded transcripts of telephone, email, and chat room conversations of small groups of traders provided the evidence of ethical weaknesses leading to attempted market manipulation that drove the post-Financial Crisis LIBOR embarrassment.

However, markets themselves typically are the best antidote to attempted market manipulation. The market solution to trader cabals formed to alter prices has always been a simple one. In a liquid market, larger market forces inevitably swamp organized efforts to manipulate prices. Cabals don’t work in a liquid market because the manipulators lose money.

The split over a LIBOR is an enormous opportunity.

Financial institutions have quite reasonably insisted on two key properties that SOFR lacks.

  • The LIBOR replacement should be forward-looking. That is, the rate should reflect the market’s opinion of overnight interest costs on average in the coming three months.
  • The LIBOR replacement should reflect the interest cost of private unsecured borrowers, instead of the lower interest costs of the Treasury.

Thus, coupled with the TBTF banks’ endorsement of the Intercontinental Exchange Inc. (ICE) candidate for a LIBOR replacement, the SFIG letter shows that ARRC’s SOFR proposal does not represent the banks and other financial institutions that are ARRC members. Worse, it raises a serious threat. If regulators seize on an index that might potentially bankrupt one or more major financial institutions during a financial crisis, those institutions do not plan to allow the Fed to pass the blame for this disastrous decision to them.

However, the banks (or a third party) will, I believe, have to do more than provide another bank-calculated index. The self-acknowledged problem with the ICE (TBTF endorsed) LIBOR replacement is that any index the procedure produces is the result of a transaction selection process by banks themselves. Thus, the ICE fix remains vulnerable to the same ethical vulnerabilities that LIBOR itself faced.

In short, any satisfactory LIBOR replacement must be a form of debt that doesn’t exist now. We could throw up our hands and use the hazardous SOFR, but this seems to be a negative way of looking at the situation.

This is an obvious opportunity to seize an enormous chunk of the financial markets in one fell swoop by addressing bond market illiquidity more generally. Moreover, it is an opportunity that anybody with the courage and the capital could pursue. The problem is one of creating a new debt market with a different structure. Such a new market would have no incumbent oligopolies and no reactionary regulators. Capital, a few hotshot IT professionals, and some people with skills of persuasion would be enough ammunition to get the job done. Island overwhelmed the incumbent stock exchanges with less.

Interestingly, in all likelihood, TBTF banks, incumbent exchanges, and regulators are at a disadvantage in the pursuit of a debt market innovation since they are married to old ways of generating revenues. An incumbent TBTF bank pursuing a new market structure, for example, would not find management friendly to ideas such as putting an end to collateral hypothecation in the repo market.

Why are we getting LIBOR wrong?

SFIG and the TBTF banks also concede that there is no existing instrument that meets the minimal standards required of a LIBOR replacement – the replacement should be a term (probably three-month, or six-month) unsecured debt instrument, traded in a liquid marketplace where recorded transaction prices are the result of the combined forces of supply and demand. SFIG’s comment letter to ARRC’s request to comment on SOFR points to a central quandary that neither SOFR nor its detractors have addressed. No financial instrument meets these criteria today.

Don’t blame the Fed. The Fed did everything imaginable to get industry support for repurchase agreements, the only existing liquid instrument where an honest broker (the Fed) records market transactions. Blame the markets themselves. Organized market participants are adopting the time-honored “See no evil; hear no evil; speak no evil.” approach. Once ARRC had endorsed SOFR, CME Group (CME) helpfully created a futures contract based on SOFR.

All that remained was for the markets to begin trading the SOFR-based instruments. However, that didn’t happen. CME volume in SOFR futures remains a small fraction of Eurodollar (LIBOR) futures volume. In itself, this is not a failing of the marketplace. It’s simply the market’s recognition that SOFR futures don’t provide adequate protection for their existing risks.

How big is the LIBOR problem?

No matter how dire you believe the LIBOR problem to be, the underlying problem of debt market illiquidity that the LIBOR problem reveals is many times bigger. A LIBOR fix only resolves the issue of illiquidity in the short-term end of the market for unsecured debt.

LIBOR became important to society when it began to appear as a factor in the cost of mortgages, municipal debt, and credit card debt. In other words, LIBOR is different from the interest cost of a corporate bond because of LIBOR’s visibility. However, of course, all bank debt, no matter how obscure, is a factor in the cost of consumer borrowing.

An exchange trading liquid tailor-made debt issues that capture the primary price risks associated with debt issuance at all maturities would have a massive beneficial effect on the cost of financing. This market would generate transactions comparable to the combined volume of the stock exchanges, assuming turnover in the two markets to be comparable.

What flaw in market structure creates the LIBOR/debt market liquidity problem? In the markets for corporate liabilities, the issuer is concerned about the market appeal of the terms upon which debt is sold only once – the issue date. After that, any action the corporation might take that benefits its stockholders at the expense of its debtholders faces a single low hurdle – is it legal? Investors are wise to devote more time and attention to debt acquisition than to share acquisition.

If bondholders could devise an instrument that liberates its holder from the negative effects on debt valuation of the decision-making power of a single issuer, it would be interesting to see what effect that would have on the position within corporate politics of debtholders relative to stockholders. One could imagine the popularity of this buyer-friendly instrument growing relative to the popularity of the current issuer-centric debt issues. As this form of debt grows as a share of the market for debt, the management of this debt would become gatekeepers for bond market liquidity. They might gradually induce issuers to write more buyer-friendly forms of debt.

The legal obligation of corporate management to consider the interest of stockholders when these interests conflict with the interests of debtholders is writ in stone. Nevertheless, there is no legal barrier to investors – the final constituency for all corporate obligations – using their influence to discriminate among debt issues. If debtholders confront stockholders with a positive payoff to pleasing debtholders, there might be multiple systemic improvements. The value of buyer-friendly debt would rise relative to issuer-friendly issues, driving down its interest cost and resulting in capital gains to both debt and shareholders. The result would be an altogether safer financial system as a whole.

Source: by Kurt Dew, Think Twice Finance | Seeking Alpha