By David Chapman
Charts created using Omega TradeStation 2000i. Chart data supplied by Dial Data.
Rob Kirby www.kirbyanalytics.com doesn’t mince words. Rob likes to dig behind the story and drill down into the numbers to unearth the shenanigans that the big banks have been up to in the markets. When the LIBOR scandal broke Rob went to work trying to see if he could figure out what the big banks were up to.
Rob spent a number of years working as a broker trading the very instruments that are at the heart of the LIBOR scandal. On a daily basis he came into contact with the banks that set the LIBOR rates. The daily LIBOR setting is a very important rate. It is probably the most important rate setting in the world, even more important than the Federal Reserve’s discount rate. The daily LIBOR setting has an impact on upwards of $1 quadrillion of derivatives and loans. It impacts almost everything from mortgages to car loans and student loans.
Yet hardly anyone knows of its existence. Why? Because the daily LIBOR setting is solely with a small cadre of banks that are members of the British Bankers Association. Each morning they submit the rates that they believe they can borrow funds in the interbank market for a host of currencies and terms. For the currencies it is primarily US$ as the most traded currency in the world.
The chart above shows three interest rate related spreads and instruments plus the US$ Index. The TED Spread is the difference between the interest rates on interbank loans and short term US government debt. Typically the Ted Spread is followed for the 3 month Eurodollar and the 3 month US Treasury Bill. The word TED is an acronym for T-Bill and ED the symbol for the Eurodollar futures contract.
The two interest rate instruments are the 3 month Eurodollar and 3 month Treasury Bills. The fourth chart is the US$ Index. All cover the key financial crisis period from 2006 to 2009 and highlights what was going on from June 2007 through December 2008 when the financial crisis first broke and it hit its nadir with the collapse of Lehman Brothers in September 2008. What followed was one of the most devastating financial collapses ever when the S&P 500 lost 56% of its value from its October 2007 highs and the world’s financial system came close to a complete meltdown.
As Kirby notes when the financial crisis first broke in 2007 LIBOR and 3 month Eurodollars rose and US Treasury Bills fell with the result that the TED Spread widened. The rush into Treasury Bills as the crisis deepened was described as a flight to safety. Normally, when there is a flight to safety the US$ rises as there is usually inflow from foreign buyers rushing to the safety of US Treasury Bills.
Kirby examined the data from the Office of the Comptroller of the Currency (OCC) and specifically looked at the holdings of derivatives of the bank holding companies with an interest rate maturity less than one year. In the 3rd quarter of 2007 there was a large $7 trillion jump in derivatives under one year held by JP Morgan and a smaller $4 trillion jump in derivatives under one year held by Citibank. When the 4th quarter OCC numbers were released the large jump of $7 trillion held by JP Morgan had disappeared although Citibank’s holdings only fell by $1 trillion.
All of the derivatives matured during the quarter suggesting that they all had original maturities of 3 months or less. But it was during this period that the Eurodollar yields rose and Treasury Bill yields fell. And the US$ fell. This appears to raise the question as to what actually caused the Treasury Bills yields to fall. If JP Morgan and Citibank collectively added $11 trillion in derivatives under one year, the hedge for these new positions is Treasury Bills. They buy the Treasury Bills in the market.
But during this period in the second half of 2007 the US$ Index fell instead of going up. This was not suggestive of a flight to safety. The fall in the US$ Index appeared to be at odds with the fall in Treasury Bill rates even as the interbank Eurodollar rate rose.
The same thing it appears happened in 2008 when the financial crisis broke. Even as JP Morgan and the bank holding companies were under severe stress due to the collapse of Lehman Brothers once again JP Morgan managed to add some $8 trillion new derivatives under one year maturity in the 1st quarter 2008 and Goldman Sachs added a large $12 trillion of derivatives with a maturity under one year. Again this creates the potential for a large position in US Treasury Bills in order to hedge the positions.
The one difference this time was the US$ Index rose during this period instead of falling as it did in 2007. As well the derivatives with maturities under one year have largely remained on the books of the bank holding companies. If anything they appear to have increased since 2009.
The major question that Kirby raises with all of these sudden changes in the derivative positions of the major bank holding companies is who has the credit lines necessary to allow JP Morgan and others to increase their holdings of derivatives so dramatically in such a short period of time. Kirby continues to believe that it is the Exchange Stabilization Fund (ESF) an arm of the US Treasury that operates with little or no accountability. The ESF was set up as an emergency reserve fund primarily for foreign exchange intervention. However, today the ESF not only continues to act in secret the ESF can operate in any market it so choses to act.
Kirby believes that the actions of the ESF have contributed to pushing interest rates to zero or almost zero across the yield curve. The US has $15.7 trillion in debt and a rise in interest rates would not be in the interest of the US. Nor would a collapse of the US$ be in the interest of the US and finally huge bank holding companies becoming insolvent would not be in the interest of the US. Through the ESF Kirby believes that the US will do what it takes in the name of national security to preserve the status quo. But if the US benefits who pays? Savers, pensioners, pension funds and holders of capital stock. As was noted at the outset – Rob Kirby does not mince words.
But now a huge scandal has erupted that has at its heart manipulation of LIBOR that has an impact on trillions of dollars of loans and derivatives. Barclays could not be the only manipulator as there are upwards of 20 banks involved in the setting of LIBOR. Criminal investigations are underway. Lawsuits are underway that could threaten the viability of the large banks at the heart of the LIBOR scandal. The fact that the scandal was revealed suggests that someone or some powerful company may have blown the whistle because it was to their disadvantage.
A rise in interest rates would not be in the interest of the US Treasury or for the banks at the heart of the LIBOR scandal because of their huge holdings in derivatives. Yet the mere breaking of the scandal could start an unravelling that plays out over time. And as the scandal unravels the markets would be at risk and it may eventually overshadow the Euro crisis.