The LIBOR Alarm – When Governments and Banks Disable An Early Warning System

Yesterday’s Markets and Money finished off by asking what the correct investment strategy is when the world’s central banks flood markets with even more money. We omitted the Bank of England adding £50 billion to its quantitative easing (QE) program.

Could the LIBOR scandal be the event that sideswipes the financial system and sends markets down? Hmm. We confess to ignoring the story for the first few days. Few things in life are as boring and depressing as examining the London Interbank Offered Rate. What the banks have to pay to borrow overnight and unsecured is, in a normal world, not news.

In an abnormal world, rising LIBOR is an indicator of rising mistrust in the credit markets. When LIBOR rises, banks get defensive and reluctant to lend to one another. When it’s not being manipulated, therefore, LIBOR is a kind of alarm in the credit markets that tells you when a bomb is about to go off.

If you think of it that way — as an early warning system that borrowers may face rising short-term borrowing costs — then it’s a lot easier to understand why someone would want to disable the early warning system. You just have to figure out who has the most to gain by preventing the communication of this information via LIBOR.

The first thought of most of the financial press — which is both shallow and wrong — is that this is another example of free market capitalism gone greedy and bad. If big financial companies are to blame for being corrupt and deceptive, the answer must be more regulation and government control.

Wrong again, morons!

The 16 London-based banks whose overnight borrowing costs are used to determine LIBOR are hardly bastions of free market capitalism. The banks fund the government and the government owns some of the banks. The inter-marriage between Big Finance and Big Government means their interests are increasingly the same — and those interests are to look out for themselves at your expense.

In this case, it’s already being reported that the Bank of England may have actually ordered British banks to understate the cost of overnight, unsecured borrowing. Why would the BOE do so? It would do so to prevent rising borrowing costs for the British government, of course. Any central bank — representing the interest of the banks and government — would do the same.

When central banks aren’t manipulating the cost of money lower than the real market price, they are intervening in market prices directly to prevent borrowing costs from rising. This makes sense when you understand that central banks exist to finance government borrowing. Suppressing LIBOR is one way of preventing rising sovereign bond yields.

Speaking of which, the pattern of capital fleeing from the periphery of a crisis to the centre continues. Yields on short-term French government debt have gone negative, while Spanish bond yields are again over 7%. The Wall Street Journal reports that the average yields on 13- and 24-week French bills were sold at a negative yield on Monday. Dutch and German short-term yields have also gone negative in recent weeks.

‘Going negative’ means that investors are willing to lose money in exchange for owning short-term northern European government debt. Ask yourself why someone would gladly pay rent for the privilege of loaning money to a government over a short term. Why?

We can think of only two answers. First, a small loss is better than a big loss. Bonds are liquid, and large institutional investors who fear the share market may value liquidity more than capital gains. This tells you how bad the bear market is. Investors are willing to accept a certain loss on bonds to avoid a bigger but uncertain loss in shares.

The other possibility is that these short-term government bonds are the last capital lifeboats out of southern Europe. It’s capital flight in preparation for a financially segregated Europe. Northern Europe will use the euro, after jettisoning Greece and making arrangements for Spain and Italy to borrow from the ECB or one of the bailout funds. The big money in Europe may want out of the South, even if it means accepting a certain loss in Northern bonds.

That is all utter speculation, but it fits with our theory of how the global monetary crisis has evolved since 2007. Marginal borrowers at the periphery are destroyed first. Money and capital migrate toward the most liquid markets. Liquidity matters more than asset quality. Credit quality is relative.

This theory is fine and good. But you’re still left with the question we began with: what is the correct investment strategy in an inflationary environment? If central banks monetise even more debt and buy other assets as part of future QE, should you sell everything and head for the hills? Or should you buy stocks? And if so, what kind?

Tomorrow, we’ll look at whether owning shares in low-priced blue chip stocks with tangible assets on the balance sheet is a better shelter for your capital than cash or commodities. If wealth destruction is guaranteed as debt is extinguished from the financial system (through write-offs or otherwise), where can you lose the least? Stay tuned!


Dan Denning
for Markets and Money

From the Archives…

How to Survive Inside China’s Financial System
06-07-2012 – Greg Canavan

China’s Economic Policy of Denial
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The Question China Has To Answer Fast to Save Its Economy
04-07-2012 – Callum Newman

How Investing in Commodities Can Prevent a Personal Financial Crisis
03-07-2012 – Dan Denning

Wouldn’t it Be Nice to Not Lose Money on the Australian Share Market?
02-07-2012 – Dan Denning

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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2 Comments on "The LIBOR Alarm – When Governments and Banks Disable An Early Warning System"

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Government wouldn’t have had a hand in this one would they?

Don’t expect to hear from any whistle blowers any time soon.

Whether it’s an Iraq war dissenter or a BOE official untimely ends appear to arise at critical junctions.

Source Bloomberg : quote Estimates of payments related to lawsuits are currently in the billions or tens of billions of dollars. The full scope of possible litigation, though, won’t be known until the details of civil and criminal investigations emerge. To get a sense of magnitude, consider this: If Libor was understated by an average of only 0.1 percentage point for a year, the discrepancy on the roughly $300 trillion in interest- rate swaps outstanding at the time would add up to $300 billion. That’s about a fifth of the aggregate capital of the 16 banks whose reports were used… Read more »
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