The World's Most Controversial Interest Rate Is Haunting Us Again

Tracy Alloway (0:08)

Hello, and welcome to another edition of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:13)

And I'm Joe Weisenthal.

Tracy Alloway (0:15)

Joe, do you remember LIBOR?

Joe Weisenthal (0:18)

I think I remember that. Yes, I do.

Tracy Alloway (0:20)

That's totally a loaded question. LIBOR, the London Interbank Offered Rate, basically the rate at which banks lend money to each other.

Joe Weisenthal (0:29)

It was a big LIBOR scandal, right?

Tracy Alloway (0:33)

Yeah, I mean, there's so much you could say about LIBOR. So it became a big deal during the financial crisis because the rate blew out, because basically all these banks didn't want to lend money to each other. So they had to offer a higher rate in order to do it. And then after the financial crisis, we found out that LIBOR had been rigged in various ways.

And that's because the way LIBOR actually works is it was done by survey. So someone would actually go to the banks and collect their estimates of LIBOR each day, and then they would come up with a sort of aggregate. So it was a self-reported rate that ended up being manipulated by some of the people that were reporting it.

Joe Weisenthal (1:14)

I was so shocked when it turned out that it was manipulated. Isn't the thing where they do the price literally called a fix?

In retrospect, I can't believe that in retrospect, something called the fix turned out to be manipulated. I was totally stunned by that.

Tracy Alloway (1:33)

All right, we are all shocked. But I will tell you something that is actually shocking now, sort of. We are all expecting Libor to be phased out at one point or another, relatively soon, actually, given what happened with the self-reporting scheme. It's supposed to be replaced by something that hopefully won't be as subject to manipulation.

But just as Libor was about to be consigned to financial market history, it was about to die, right? It has come back from the dead, effectively, to haunt financial markets.

Joe Weisenthal (2:15)

Ooh, I'm intrigued.

Tracy Alloway (2:17)

Yes, so we are going to call this episode Revenge of the Libor. And we have the perfect person to talk about all this, not just what happened in 2008 and then during the Libor manipulation scandal, but also to discuss what's happening now and why people are once again discussing Libor.

Joe Weisenthal (2:36)

Let's do it.

Tracy Alloway (2:41)

So our guest for this episode is Scott Peng. He is the CEO of Advocate Capital Management and he also used to be head of US interest rate strategy at Citigroup, a fact that will be relevant in just a few minutes. Scott, thanks so much for coming on.

Scott Peng (2:59)

Thanks for having me, guys.

Tracy Alloway (3:01)

So I'm so glad we could have you do this because you truly are the perfect person to talk about Libor because you were one of the first people, if not the first person, to actually point out that it looked like Libor potentially was being manipulated in some way. Is that right?

Scott Peng (3:18)

Yeah, and it's been a long and strange journey since that point. And I would sort of contend with the statement that Libor is dead because rumors of its death, as we'll discuss, are somewhat greatly exaggerated.

Joe Weisenthal (3:32)

So just to back up, Tracy mentioned in the intro, Libor being the rate that banks use to price short-term lending to one another. Just give us the sort of quick history of how this rate became a thing.

Scott Peng (3:47)

Sure. Before I started in the business in the 80s, the key short-term rate was actually not Libor. It was actually three-month treasury bills. Libor came along in the mid-80s as a way for non-U.S. domiciled banks to obtain financing in the Euro-dollar market.

And over time, with increased usage, with its center status in the middle of interest rate swaps, it took over the benchmark status from three-month T-bills, and it's been the benchmark since the late 80s, early 90s. So that was really the genesis of Libor. And at some point, maybe we'll have some time to touch back on that, because I think going back to three-month T-bills may actually be a very useful thing in terms of considering Libor replacements.

Tracy Alloway (4:36)

Yeah, we're definitely going to talk about Libor replacements. But before we do, just to set the scene, remind us what Libor looked like in 2008 in the depths of the financial crisis, because we not only saw Libor blow out, we also measured Libor against OIS, the Overnight Index Swaps, basically a risk-free rate of lending pegged to typically fed funds futures.