Looking for Problems In All the Wrong Places

Looking for Problems In All the Wrong Places
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The first Iranian shah was crowned in 1796.  Agha Mohammad Kahn, a leader of the Turkmen Qajar tribe of Azerbaijan, had unified the former Persia setting his capital in the small village of Tehran near the ancient Persian city of Ray, now Shahr-e Rey. He was assassinated the very next year.

Throughout the 1800’s, the reign of the Qajar dynasty was characterized as cushioning the imperial forces of Tsarist Russia against those of British India.  Modern Iran would not truly be born until 1901. That was the year when the British-owned Anglo-Persian Oil Company obtained exclusive rights to production and exploration from Muzaffar al-Din, a Qajar shah who had come to the throne in 1896 when his father was assassinated. 

Muzaffar was a ruler out of some Hollywood movie, obsessed with a lifestyle of extravagance no matter the cost to the people of Iran.  His relationship with Anglo-Persian was born out of necessity rather than foresight.  Disaffection with his rule and the disorder that accompanied it led to a new Iranian constitution on December 30, 1906.  Shah Muzaffar died five days later, and in 1908 Anglo-Persia struck oil at Masjid al-Suleiman. 

World War I and the fueling needs of the British navy brought London and Tehran close, at least for a while.  In 1925, however, a cavalry officer overthrew the Qajar dynasty.  Reza Shah wanted back the now vast and developing oilfields from the British, under exclusive control of what had become the Anglo-Iranian Oil Company.  Several overtures were made to Nazi Germany, leading to an August 1941 agreement between Winston Churchill and Josef Stalin to overthrow him in favor of his son Mohammad Reza Pahlavi.

The Americans embraced the new shah after the war as an important member of the anti-communist bloc.  The location of Iran and its oil reserves sealed the relationship, even though the British at the time still controlled the crude.  The idea of nationalizing Iranian production and rights never truly died, and in the 1950’s the British hatched another plot to foil the plan of Iran’s Prime Minister under the shah, Mohammed Mossadegh, to do so. 

It led to severe unrest in 1953, when US officials convinced (Operation Ajax) Reza Pahlavi to issue a royal decree forcing the Prime Minister to step down in favor of Iranian General Zahedi.  Mossadegh, however, sought the arrest of Zahedi and the shah for a time was forced to “vacation” in Italy.

The shah safely back in Iran after protests and counter-protests, in June 1954 the oil issue was resolved in favor of Anglo-Iranian and three other American oil companies. They would receive concessions to distribute the petroleum and refined products from now Iranian-controlled wellheads and refineries.  Iran would also join the Central Treaty Organization the Eisenhower administration supported as an anti-Soviet league.

When Iran had joined the IMF on December 18, 1946, under the auspices of the new Bretton Woods framework, the Iranian rial was exchanged at 32.50 to the dollar. It had been set at 11.20 in 1933 but was steadily devalued throughout the thirties as Iran backed away from Britain (and Britain away from gold). It was officially debased on October 1, 1941, shifting from 16.35 to the dollar to 35.25.

The political turmoil of the early 1950’s created a robust black market for rials.  By 1955, the prevailing private rate was 81.00. Iranian authorities now firmly under the renewed shah had on March 21 that year introduced no less than eight official exchange rates (32.50 for government transactions; a “student” rate of 41.50; for export receipts 75.00; etc.).  In 1957, the rial was then redefined again, this time by a gold content of 11.732 milligrams, or 75.75 to the dollar based on Iran’s gold reserves.

The gold “rules” stabilized Iran’s currency for a time into the early 1960’s.  In 1964, the government officially abandoned sterling for denominating foreign reserves and exchange.  The dollar was to be used as its replacement. 

That meant a great need for dollars as liquidity, including for all kinds of oil activities trading to investment. By 1967, Iran had become the world’s sixth largest crude oil producer, yet it couldn’t meet the monetary needs of a modernizing industrial state.  Its checkered political history had precluded its attempts at international financing.

The country had in 1968 drawn $31.25 million in various foreign currencies from the IMF out of necessity. This was from the perspectives of both parties far from ideal. The governor of Iran’s central bank, Khodadad Farmanfarmaian, was dispatched to London to seek alternatives.  There in 1969 he found “the Greek banker”, a top official of Manufacturer’s Hannover. 

Minos Zombanakis came to Manny Hanny (as the firm was affectionately known) indirectly.  Several years before this very bright Harvard grad (who entered and finished its graduate school without the prerequisite undergrad qualifications) by way of Nazi-occupied Crete had found himself in Rome as the American bank’s Middle East representative. In Beruit in 1956, Zombanakis had met Farmanfarmaian and remained in touch throughout the 1950’s and 1960’s.

So it was fortuitous when the Iranian central bank sought out an $80 million foreign loan, having already been connected to the Greek banker where its officers went first.  Not only was there a personal relationship between Zombanakis and Farmanfarmaian that made such things possible, Minos had become the head of Manny Hanny’s London subsidiary, having convinced his New York bosses to allocate all of $5 million to start it up.

There had been throughout that decade an enormous developing pool of currency which bankers in London were already making bank off of.  Wall Street firms wanted their share, too.  These were, after all, dollars if offshore.  The eurodollar market, as it came to be known, was opening up possibilities that hadn’t existed since October 1929.  The eurodollar, not dollar, would resurrect cross-border money flow and unleash the truly globalized modern world.

But first it had to define itself.  This was a blackhole, the Wild West of money regimes.  That characterization is perhaps too harsh, as it wasn’t much for conflict just a lack of any sheriff.  It was run by gentlemen’s agreements, where befouling one’s reputation meant immediate ostracism, individual or firm, from the lucrative business with a vast and truly unlimited future capacity before it.

On the other side, there were the needy, those currency-starved firms and a great many countries like Iran who desperately sought access to this untapped resource.  The Greek banker was just the guy to come up with the answer.

Minos knew the $80 million would never be absorbed as a single loan or bond; Iran was just too risky despite itself and its oil.  The credit would have to be syndicated, but on what terms?  Getting all the Lombard Street banks together on them would be exceedingly hard even in eurodollars. 

Credits like the Iran deal were unattractive in too many dimensions for a conventional deal.  A high rate would be too expensive for Iran, increasing the risk, and with the Great Inflation already well-underway (though they didn’t know it at the time, even in 1969 bankers knew what the risks were) prospective syndicate partners needed assurances to even consider the possibility. 

Necessity being the mother of invention, Zombanakis struck gold, or what passes for modern gold.  He would solicit from each syndicate party its funding costs every quarter just before a payment date.  The interest on the loan would be recalculated at that time to take account of the variability of short-term interest rates, offering the banks some protection against inflation and liquidity.  Minos called it the London InterBank Offered Rate. 

So was born LIBOR, until the 1980’s an average of offered, not transaction, rates that hardly anyone noticed.  It fit very well the overall eurodollar paradigm, for while nobody paid much attention to LIBOR the eurodollars it referenced were silently taking over the world. Derivative instruments weren’t new in the 1970’s, but the fluid use of them owing to both the eurodollar’s rise as well as technology meant capacities even the Greek banker could not have foreseen or dreamt. 

Up until 1986, LIBOR was largely a private affair of banks participating in the syndicated processes.  Margaret Thatcher’s Big Bang reforms led to its standardization under the British Bankers’ Association (BBA).  These changes were at the time radical: City firms would embrace technology, the open-outcry system of exchange for shares and derivatives was scrapped in favor of electronic trading. The “jobbers” and brokers would be combined, or now could be combined, meaning that financial businesses would no longer be pegged to a single capacity. Brokers could be market-makers and vice versa. 

More importantly than those, the Big Bang embraced all the allures of globalized money.  London had been an important center of the eurodollar market from its very beginnings, but this was meant to make it the vital beating heart of it all.  The combinations of these factors would be finally unleashed in the 1990’s with a full-scale, mature system that was unlike any recognizable form of money in history. 

It is for this reason the assumed center of the dollar-verse, the Federal Reserve, simply shifted its game by response.  It would no longer target money supply because even its officials admitted they didn’t know what counted, or might count, as money. They would instead guess.  Alan Greenspan’s Fed would move the federal funds rate a quarter point here or there, and if inflation, the great gauge of hidden monetary conditions in the real economy, behaved according to central bank specifications it was merely assumed the federal funds rate mischief was the reason. 

Therefore, as the eurodollar system came to dominate and create the environment for globalism to be completely embraced, Alan Greenspan happily took, and was uncritically given, credit for its bright side. But it was building a world that wasn’t all good, even as the 1990’s (US) and 2000’s (EM’s) seemed for most within them often “miraculous.”  You know what they say about things that appear too good to be true; they almost always are.

On June 22, 2017, the Alternative Reference Rates Committee (ARRC) announced to the world that, for the US anyway, the GC repo rate for US Treasury collateral would replace LIBOR in setting prices for trillions upon trillions of securites.  Before the announcement I doubt anyone had heard of the ARRC, and even those that had (in the media especially) perhaps don’t really grasp what it is attempting to accomplish. 

Even raising the topic of LIBOR needlessly sets off alarm bells. It’s understandable to some small degree from the standpoint of derivatives.  There are around the world hundreds of trillions in notional positions that are often characterized as capable of blowing up the world.  But they already did that, which is entirely the point.

The true sticking point is not what might set for reference their structure.  In this one context, the lesson of the Greek banker is that there are so many others like him.  The true greatness (in a limited sense) of the eurodollar wasn’t its dollar pedigree or offshore location, but that those combined allowed for it to take almost any state it wished.  It was so flexible that it could evolve often profoundly, as it had in 1969 for Iran’s so-called petrodollar experience.  How it prices the liabilities it creates is in reality an afterthought – it will always find a way to price.

The eurodollar was a chartalist’s dream. And because of that it became our nightmare.  Evolution without constraint sounds in theory terrific.  But gentlemen’s agreements can’t govern a multi-trillion or tens of trillions system operating with impunity across all geographical boundaries.  To start with, the system has to make internal sense without fatal contradictions.

What brought it all down exactly ten years ago next week was very simple to characterize from a general perspective.  Because of the fluidity and evolution, it was always assumed that volume growth equated to low risk.  Like a perpetually swimming Great White shark, as long as it was moving forward it would never die.  The LIBOR element of it, and other covenants like it, helped in creating and fostering the illusion.  A standardized interest rate swap contract presumes that all parties know the terms. The various and quite imaginative uses of standardized swap contracts of all varieties made that much less so.

The ARRC was created in 2014 on the official report recommendation of the Financial Stability Oversight Council (another government body no one has ever heard of).  The FSOC was established by Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act as a response to what happened on August 9, 2007, though the reforms embodied within Dodd-Frank importantly don’t recognize that date for anything of importance.  The law was a generic response to the outcome of the Great Panic of 2008, which was a eurodollar event first and foremost.  And in the middle of it was LIBOR, not because it didn’t work but because it did!

The often massive spread between LIBOR and federal funds (or OIS, if you prefer) starting in August 2007 was really all anyone needed to properly diagnose the crisis.  Rather than appreciate this, post hoc“solutions” have conflated the cheating that went on in fixing the rate with systemic flaws of the eurodollar system as a whole (without, of course, officially recognizing that the eurodollar system exists and in the capacities it does).

On that endorsement, the Federal Reserve Bank of New York convened the Alternate Reference Rates Council on November 17, 2014, just a little over a month after the dramatic events of October 15 perfectly illustrated the ongoing systemic flaws.  The Council’s job is:

“…to promptly identify alternative interest rate benchmarks anchored in observable transactions and supported by appropriate governance structures, and to develop a plan to accomplish a transition to new benchmarks while such alternative benchmarks were being identified. Greater reliance on alternative reference interest rates will make financial markets more robust and thus enhance the safety and soundness of individual institutions, make financial markets more resilient, and support financial stability in the United States.”

It is, as with many similar attempts, a commendable task.  No one wishes to repeat that panic. But in trying not to, authorities are making another grave error.  We won’t have a second 2008 because we are not yet over 2008. The worldwide economy has never been able to recover because the monetary system that built it hasn’t. 

The focus on LIBOR is a symptom of this blunder.  The reference rate isn’t the problem (this isn’t to say a better method isn’t needed or necessary, but the focus on it is hugely misplaced), the system that gave us that reference rate, or any others like it, is.  The issue for the global economy is eurodollars; the issue for eurodollars isn’t LIBOR but systemic capacity. 

Finding a better way to do eurodollars is the wrong way of thinking.  There is no better way to do eurodollars. The Q2 earnings reports from all the big banks should once again convince anyone of this fact.  The money dealers can’t make money in money. That has nothing to do with how dealers price their liabilities, and everything to do with why those derivatives are accepted as liabilities everywhere.

As I wrote a few weeks ago:

“And so the world is stuck on a monetary system that makes no real sense: banks make money when the economy returns to normal, but the economy won’t return to normal until monetary conditions do, and monetary conditions can’t unless banks can make money in money. After ten years of this, it seems painfully clear that it can’t change on its own, leaving drastic, radical intervention as the only real solution. The eurodollar as a credit-based monetary system has far exceeded its useful life.”

Ditching LIBOR won’t change that.  Re-standardizing credit-based money leaves intact credit-based money.  Substituting the GC UST repo rate won’t stop banks from further shrinking, including their dealer activities that are this credit-based eurodollar. 

The impulse and desire to fault LIBOR, however, is just the symptom of this difficulty coming from a blind perspective (thanks to Economics and its credentialed purveyors).  Everyone except Economists and certain politicians know that “something” is wrong with the economy, and many further recognize that it has to do with at least the financial system and banks.  It makes sense in the same way Brexit makes sense to try to get at what that “something” might be.

But both Brexit and LIBOR’s demise don’t change anything that needs to be changed.  It appears increasingly likely we can add the election of Donald Trump to that list.  I wrote more than a year ago that the elevation of Trump (as Bernie Sanders) to serious contender was a step in the right direction, not because he might have the answers but because it showed how serious Americans were in trying to find them.

I think the LIBOR debate falls in a similar if ultimately disappointing category; an attempt to get at the problem but falling short of grasping what the problem really is.  Some officials are looking in the right place but still can’t see it.  

Ultimately, the $80 million for the shah’s Iran had the same effect. It may have birthed LIBOR, but it was no shield for the Pahlavi’s from inherent systemic instability drawn ultimately from native illegitimacy.  It’s an almost perfect parallel.  It took a further ten years for that insecurity to trigger paradigm change in Iran (and not for the better).  Time can unfortunately move very slowly for big things. Though swapping GC repo for LIBOR for swap references and more isn’t close to a solution, it’s still a positive in that even after all this time a broad search for resolution, even evolution, goes on. 

Someday, hopefully not too much further along, they just might get it right.  If not, malcontent will surely break out and in truly unpredictable ways. Just ask the shahs of Iran.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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