My friend Christopher Whalen has written an excellent commentary on the ongoing debate about LIBOR versus SOFR (the secured overnight funding rate). Here’s the link to his publicly available essay: https://www.theinstitutionalriskanalyst.com/post/libor-is-dead-long-live-sofr-really. We recommend Chris’s analysis as a “five-star must-read” for any investor, banker, credit officer, analyst, or student of monetary economics and policy.
LIBOR still is a market-based interest rate. SOFR is a theoretical construction that continues to have problems in development. LIBOR gives market agents a way to compare risk in the banking system with riskless assets in the US Treasury-guaranteed short-term funding markets.
LIBOR has a seasoned (and blemished, but now fixed) history.
SOFR has no history.
Even with the many new policy implementations by the Fed during the COVID crisis, the Fed has retained the references to LIBOR in interest-rate setting. The participating banks of the United States that serve as the conduits for the new Fed policy tools insist on LIBOR references, for necessary reasons. SOFR isn’t functional. The documentation for the (PPP) loans says (I will paraphrase for simplicity), “Use LIBOR now and SOFR later when it is ready for the switch.”
So Chris Whalen has asked a profound question: “If it ain’t broke, why fix it?”
Bingo! The impetus behind SOFR as an alternative to LIBOR is not a logical case but is tied instead to some egos who are now defending SOFR even though its flaws were revealed during the REPO-rate spike. Whalen has politely pointed out the facts and the culprits.
So what does an investor do when the classic multidecade measure of banking system risk versus riskless spread is being replaced by a non-spread that is really tied to short-term Treasury-bill yields? At Cumberland, we make up our own measure to assess a market-based pricing of this credit spread. We do this by comparing the interest rate actually paid on the government-only money market funds versus the interest rate paid on the prime money-market funds. The rules allow one of those funds to hold bank paper, while the other fund can own only government-guaranteed paper. The difference between the two yields is determined by the market-based pricing of the bank-related paper that exists in one of the portfolios and not in the other.
We survey the large money-market-fund sponsors, and we select only those relatively large funds that sponsor both types of money market funds. We then have to adjust the yield, since about a third or so of each of those portfolios is identical and government paper only. It is the other two thirds of the portfolios that creates the spread. I’m rounding here to make this easy for readers.
The result is a back-of-the-envelope way to assess the risk spread.
We then compare that spread to the LIBOR-based spread to US Treasury bill yield of the same or very closely similar maturities.
What do we see? The LIBOR-based spread and the money-market-based spread are about the same, as you would expect.
Conclusion: It ain't broke. There is no need to fix it.
LIBOR could be fully restored and fully supervised and fully functional. It is currently working in exactly that way in daily market activity.
All that needs to happen to reverse the “get rid of LIBOR” decision and the “let’s create SOFR” decision is a policy choice to conduct, in broad daylight, an open and honest reexamination of the merits of each.
Chris Whalen is right. Now is the time to restore LIBOR fully instead of just extending and re-extending its use because SOFR keeps having problems. |
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