Libor 2 – What Should Actually Scare You

Two posts in one week – not my normal style.  I promise not to inflict this on you again.

After my post on Libor the other day, my friend Bill eloquently busted my chops.  If you haven’t read his comment, you should.  He made an eloquent case that the ends never justify the means, and did it all while quoting Nietzsche.  I am humbled.  Bill, if I am Man, you are Superman.

There, I’ve done it – a blog post containing a Nietzsche joke.  OK, not a great joke, but Nietzsche wasn’t exactly a barrel of laughs.

If I were wise, I’d quit while I’m ahead.  I’m not wise.

Here’s what the Libor scandal reveals that all of us should find much scarier than the actual rate fixing.  A recent article in the Wall Street Journal states:

“More than $800 trillion in securities, derivatives and loans are linked to the Libor, including $350 trillion in swaps and $10 trillion in loans, including auto and home loans.”

$800 trillion is a lot of money.  Except that it’s not actual money.  Global GDP – the total size of the world economy – is $70 trillion, which coincidentally is also about the size of the global money supply.  So Libor-based obligations alone total more than 11 times the actual amount of money in the world.  That doesn’t count non-Libor based obligations – which include at least $250 trillion more in derivatives.  (The total derivatives market is estimated at $600 trillion, from which I’ve subtracted the $350 trillion of Libor-related instruments cited by the Journal).

Derivatives are supposed to make it easy and inexpensive to hedge real risks.  But what we have is a massive, inverted pyramid – something on the order of a quadrillion dollars of exposure precariously perched on top of a “mere” $70 trillion of real money. That feels more like a time bomb than a market.

What can we do about that?  Here’s an idea.  How about a law stating that you can only use derivatives to hedge real assets or liabilities.  By “real” I mean “we can find it on your balance sheet.”  How to enforce it?  Let’s employ the Saudi system of justice – punishment that far outweighs the crime.  It works like this:  “We’re going to conduct spot audits.  If you hold a derivative for which we can’t find the corresponding real asset or liability, we’re going to take you out back and cut off your calculator.”

Admittedly, I’m being impractical here.  A law like this would have to be enacted and enforced everywhere.  But getting back to an environment in which financial markets support real economic activity instead of overwhelming it sure feels like a good idea.  It would also be a world in which we wouldn’t need to be grateful for little – or big – white lies.