This guest commentary was written by Christopher Whalen. It was originally posted on The Institutional Risk Analyst. This piece does not necessarily reflect the opinion of Hedgeye.
Earlier this week, the Federal Reserve Board and other agencies blinked on the ill-advised transition from LIBOR as a pricing mechanism for financing various types of assets and secured money market transactions. The agency statement delaying implementation to 2023 is below:
“The Federal Reserve Board, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency today issued a statement encouraging banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021, in order to facilitate an orderly—and safe and sound— LIBOR transition."
Unfortunately, as we wrote back in September in National Mortgage News (“Housing market needs SOFR alternative — now”), the proposed “replacement” for LIBOR -- the secured overnight funding rate or SOFR -- is not really a market price at all.
“According to the Fed, SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by Treasury securities,” we wrote in NMN. “In fact, SOFR is an imaginary, backward-looking benchmark dreamed up by the economists at the Fed with no discernable market.”
The 2017 decision by the Fed to do away with LIBOR is one of the most ill-considered and thoughtless actions taken by the US central bank in many years. Not only did the Fed displayed its ignorance of the workings of the US capital markets, but it also revealed its arrogance and stupidly.
Simply stated, LIBOR is a price for conducting financing in dollars. SOFR is an economists’ wet dream, a backward-looking measure that may seem interesting from a research perspective, but one that lacks actual liquidity. As one reader of The IRA said this week: "Glad they realized that an unsecured loan to a possibly TBTF bank should be priced differently than Tri-party repo using "AAA" collateral and margined every night." Ditto Alan.
The solution for the “problem” with LIBOR is to fix the existing benchmark, not to dream up some farcical concept and then try to bully insured depository institutions to use SOFR for actual risk taking. We understand that many banks have told regulators privately the same thing we hear from clients in the too-be-announced (TBA) market for mortgage backed securities (MBS): SOFR is a non-starter and must be discarded.
As late as last week, the Fed and other regulators were trying to bully the large dealer banks to stop using LIBOR by December 31st. The resounding answer: “Foxtrot Oscar.” Indeed, a growing number of analysts seem to have reached the same conclusion that we made months ago, namely that asking banks to take tens of billions of dollars in risk every day using SOFR as the pricing mechanism would be unsafe and unsound.
You see, there is no actual market for SOFR and no real trading activity in this ersatz benchmark. The Fed party line claims that SOFR is built upon "a deeply liquid market in U.S. Treasury securities," in fact the Fed's economists missed that very opportunity entirely and instead had to create a new benchmark of their own design.
Any “risk” from the LIBOR transition has been created entirely by the Fed itself. Michael Held, Executive Vice President and General Counsel of the Federal Reserve Bank of New York, made these comments in September:
“I have said before that the end of LIBOR presents a rather frightening—or awe inspiring, depending on your perspective—litigation risk. But it’s not just litigation risk. The LIBOR transition encompasses a whole panoply of risks. Yes, legal risk, but also operational risk, credit risk, regulatory risk, reputational risk, you name it—LIBOR has it all. So the possibility of a failed LIBOR transition is something that should keep all of us up at night.”
No, what keeps us up at night is the incompetence and arrogance of the Fed and other regulators. There is no need to get rid of LIBOR. Fix the process for setting the rate in dollars and other currencies, declare success and move on to more important problems. The LIBOR transition is a “problem” that exists first and foremost because of the muddled thinking in the minds of global bank regulators.
If LIBOR does need to go away, the obvious answer for the US market is to price MBS against the forward market for these securities, that is, TBAs. But this solution was apparently too obvious for the Fed’s staff in Washington. These are the same bright lights, keep in mind, that decided to “go big” in April with open market purchases and nearly tipped over several agency and hybrid REITs in the process.
If we count the year-end 2018 liquidity fiasco and the September 2019 redux, the April 2020 episode with the massive resumption of QE by the Federal Open Market Committee marks the third time that Chairman Jerome Powell has almost run the US financial markets aground.
While investors may think that the Federal Reserve Board is a mechanism for stability in the financial markets, we respectfully beg to differ. Forcing US banks and investors to adopt the SOFR standard would violate federal banking laws and would put US banks and the housing market at risk – and for no good reason.
Fortunately, the Fed and other agencies now have an opportunity to regroup and consider some alternatives for dealing with the LIBOR problem. More than any technical factors, the Fed and other agencies were embarrassed by the LIBOR price-fixing scandal and feel inclined to kill the benchmark in order to restore their collective self-esteem. But does this really serve the public interest?? Really?
First and foremost, the Fed needs to start listening to its banks and the markets more broadly. Given COVID and the economic disaster taking shape across the US, do we really need to be dealing with this now? To extricate itself from the present impasse, the Board of Governors should make clear that SOFR is not meant to be the only possible alternative to LIBOR and that US banks may select any established market benchmark as a substitute market price.
But is Chairman Powell listening?
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington.
This piece does not necessarily reflect the opinion of Hedgeye.
