"To get what you want, deserve what you want."
- Charlie Munger
This article begins a journey along a path originating in the smoking ruins of the market index for short-term unsecured funds. LIBOR has blown up. The bright side of the LIBOR debacle is that it is packed with lessons that may be applied across the entire spectrum of financing. This article begins an examination of the applications of LIBOR lessons. If we don’t learn from LIBOR’s history, we are doomed to repeat it. We begin with the ruin of LIBOR itself and the implications for improvements to the markets for short- and long-term debt.
What went wrong? Looking back, we made some mistakes at LIBOR’s birth.
- We didn’t grasp the fundamental reason for LIBOR’s creation. LIBOR came into being because regulators in the United States - like regulators everywhere - look backward. They apply the fixes of yesterday to today’s problems. Question 1: Why are we expecting regulators to fix the problem they made?
- Neither did we grasp the significance of LIBOR’s role. LIBOR was not born, as we then believed, to find a way to safely lend money to the Shah of Iran. LIBOR was the template upon which all high-volume commercial loans were to be based, in the new world of volatile interest rates that began in the 1970s.
- Further, LIBOR’s megabank designers considered only their own needs. LIBOR-builders assumed the banks would always be the primary source of money, and that their profitability was the primary concern. The banks attempted to avoid the demands of the marketplace altogether by funding themselves with non-negotiable time deposits. The needs of borrowers were placed a distant second. And the twilight of the banks was not a consideration.
- Finally, we did not consider the greater issue. What is the best way to move money across the sell-side, buy-side, divide in any market? Banks, understandably, were focused only on the wholesale deposit market.
Long- and Short-term Debt
Debt has many masters. Each of debt’s three masters - issuers, markets, and buyers - has a separate set of needs. The problems of the long- and short-term markets are quite similar, but the participants and the language they use is different. So, we split the discussion into short-term debt, on one hand; long-term debt, on the other. We further divide the debt marketplace into borrowers/issuers, markets, and lenders/buyers.
- Issuers: The origins of borrowed long-term issues are necessarily granular. Most corporate debt is in the form of bonds. Any substantial firm, and there are many thousands, will issue bonds at multiple maturities and for many different classes of risk. It’s what corporate debt investors and bankruptcy law demand. Lenders to corporations must know where they stand.
- The market: But markets must meet their own imperatives, different from those of corporate issuers. The primary imperative for markets, the second leg of the long-term debt finance stool, is volume. To generate volume, markets demand instrument uniformity. Corporate bonds completely fail the uniformity test. Too many issuers selling too many separate issues. The only debt instrument that comes close to leaping the uniformity hurdle is Treasury debt. As a result, the Treasury market is overworked. Stretched thin, the Treasury has issued debt that tries to be all things to all people. The Treasury offers everything from zero-coupon issues, to the more common bills and notes, to their own version of floating rate paper. But this multi-issue policy has been rejected by the marketplace, which lumps the whole kit and caboodle into a vast pool called repo collateral. A single vat of overnight money. So Treasury long-term debt has been transformed through repo into short-term debt. Simplify and standardize; that’s what markets do.
- Lender/buyer: Investors have yet a third, distinct, set of needs. Repo disastrously fails to meet the needs of buyers of long-term debt. First, they are using this overnight debt to finance long-term risks such as insurance and pension claims. An overnight rate just doesn’t get this job done. Second, they are commercial firms, facing commercial risks that depend on the vicissitudes of the economy. The Treasury based repo will gain value when commercial risks lose value; then lose value when commercial values improve.
But repo also fails to meet the needs of index-based short-term borrowers. To finance their risky activities, borrowers need debt financed by commercial obligations - the paper that matches borrower credit risk and maturity profiles. Not those the market wants; not those the issuers want. Repo does that for nobody on the buy-side.
LIBOR did meet the needs of commercial bank borrowers. The test that LIBOR failed was that it was issuer-specific. In a vain attempt to issue generic bank wholesale unsecured debt at a uniform rate to meet buy-side needs, the banks denied the specificity of each bank’s risk. This was a minor problem in the early days of LIBOR when banks were more alike and the class of banks with global reach was larger. But the system collapsed because the megabanks simply became too disparate and too few.
What to do about short-term debt? And who should fix it?
The solution to the needs of the marketplace and those of borrowers in the short-term market is, thankfully, similar to the solution for the long-term market.
- How to go about solving the problems of the debt market? The buy-side should be heavily involved. The buy-side should communicate with the sell-side within a newly created marketplace to form a compromise. And importantly, the two sides must have a place to stand. This suggests the need for an exchange that returns from publicly-held corporate form to a mutual form of ownership.
- Finally, an unfortunate fact stands out. The instrument described, corporate debt with a regular issuance and a constant term to maturity, doesn’t exist. So, this instrument must be manufactured from another.
Repo tries to do this, but it fails on two fronts. First, repo uses the wrong raw materials. Second, the collateral-based repo is an out-of-date source of risk protection.
The raw materials problem
Repo bases its volume on the stock of available rated securities, creating a disparity between the risky unsecured credit basis of the money that funds of index-based loans, and the less risky basis of the repo collateral itself. When risk premiums rise, the spread between secured interest rates and unsecured interest rates expands. When the loan is priced on the basis of low-risk SOFR, but the lender’s cost of money is based on high-risk unsecured debt, the spread that makes index-based credit viable goes straight into a hole in the ground. Catastrophe will ensue.
Depending on collateral-based lending to ration credit
Why not? Because collateral lending packs a double whammy for repo-based borrowers. First, lenders react to increased market risk by increasing collateral “haircuts,” the amount of collateral in excess of the amount borrowed. So as haircuts rise, the amount of repo borrowing that a given stock of collateral will support plummets. Worse, repo lenders “fly to quality.” That is, the collateral lenders accept also shrinks. The result is a vicious cycle of shrinking loans.
Second, a repo is based on collateral. Collateral-based credit is out-of-date. It is an inefficient way of preventing systematic risk. In ordinary circumstances, there is no way for market participants to know how safe repo-based loans are. Safety depends on an obscure measure called the velocity of collateral. For example, collateral acceleration is greater in the UK than in the US. Ergo, as with the ill-fated LIBOR, repo lending is basically an over-the-counter market where London rules attract repo, the LIBOR replacement, to avoid stricter US rules.
UNICOM, A unit cost of money
A newly manufactured instrument, the Unified Cost of Money ((UNICOM)) must meet several criteria.
- A single issuer credit. The uniformity that markets forced on the Treasury by producing repo teaches us that.
- A term credit. The Fed’s version of a LIBOR replacement, SOFR, doesn’t meet this criterion. The market gazed on the morass of Treasury issues, and took the easy way out, pledging everything overnight. We can do better.
- Corporate-debt-based. This is the tough get. Most likely the choice of an issue will be overnight commercial paper, the easiest thing to get past the rating agencies. Also, the easiest to reverse out at any sign of issuer problems.
- Some sort of pass-through, to transform the maturity from the available overnight maturity to the maturities the buy-side needs; both for loan pricing, LIBOR’s former role, and for matching the maturities on the pay side of buy-side entities such as insurance companies and pension funds.
These criteria strongly suggest that the buy-side should be heavily involved in the market design. The instruments will most likely need a package to transform overnight to term paper. The market is not clearly in the domain of either the SEC or the CFTC. Probably both will lay claim. The good news is that the market structure for short-term commercial debt-based instruments will be identical to that for long-term instruments.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.