It seems some banks are giving phony LIBOR quotations that don’t reflect the true rates at which they accept deposits. In the perfect financial system, beloved of regulators and academics, this kind of discrepancy shouldn’t happen.

In the real world it does, and I’ll explain why.

The LIBOR system was set up in the 1960s, when the market for dollar-denominated bank deposits outside the United States grew big enough to worry about. On a daily basis, the British Bankers Association would go to 16 banks, which were thought to be top quality, and ask those banks at what rate deposits were being offered. Assuming an honest reply, the data would be compiled to determine the average rates at which deposits were offered to prime banks. The average of the 16 banks becomes that day’s LIBOR – for 1-month, 3-month, 6-month or other period deposits.

Should be a foolproof system, right?

Not quite. To see what can go wrong, let me share a little personal story. Ten years ago, when I was working in Zagreb, Croatia, I advised on the establishment of a LIBOR-type market between Croatian banks for 1- and 3-month deposits in Croatian kuna. We called it the “ZIBOR” market. Realizing that very few Croatian banks were solid credit risks at that time, I suggested that the bankers’ association restrict the system to no more than the three top banks.

Naturally, since I was only the advisor, they ignored me and let in all the large members of the association – seven in all.

The system worked fine for a time, but then a credit crisis struck. NATO got upset about Kosovo and started bombing the neighborhood. Only occasionally did bombs accidentally fall on Croatia, but the bombing played merry hell with Croatia’s tourist business. The result was a liquidity crisis in Croatia, and big trouble in the ZIBOR market.

I heard some grumblings that ZIBOR had become unrealistic and been investigated. There were two problems:

• First, one of the ZIBOR banks, Splitska Banka, was in such horrendous shape that no other bank would offer it deposits at all – not at any rate. Splitska was naturally interested in continuing to participate in the immense honor of the daily ZIBOR fixing, so its dealers would insist on going last. They would ask what the other banks had quoted, and then quote the average. Perfectly sensible solution, as I told everybody, provided none of the other banks took to doing it – it just meant there were only 6 banks really quoting ZIBOR, but six was still plenty.

• The second problem occurred as liquidity got worse, and consisted of banks complaining that they were actually being asked to place deposits. Other banks would ring them up and ask them to place deposits at ZIBOR. They complained that this was impossible, since most days, they hadn’t any money. Admittedly, the ZIBOR “reference amount” (the amount for which the quotation was supposed to be good) was only 100,000 kuna, or about $15,000. But some days even that amount was difficult to find. They wanted to reduce the reference amount to 10,000 kuna ($1,500), presumably so that if they were asked to place a deposit, the bank’s chief executive officer could conceivably raise the money on his credit card!

So much for emerging-markets banking. When I returned to the United States in 2000, I thought I had left all that behind me. Apparently not!

Banks are now apparently making fake LIBOR quotes on the grounds that they don’t want to be thought of as a credit risk, from which other banks would then demand a premium. Just like the old days in Zagreb!

But given the subprime mess, some large banks are rather dodgy credit risks, and they should be paying a modest premium for their deposits. In the 1974 credit crunch, some perfectly respectable Japanese banks paid a premium of as much as 2% for their short-term dollar deposits.

In these volatile markets, any whisper of trouble over a bank makes other banks’ dealers not want to place money with them. Their feeling is that there’s no point in getting fired for doing business with another bank that goes bust, especially as you’d probably be losing your job at the bottom of a bear market, when times are tough. So it’s not surprising that the LIBOR system is wobbling a bit.

Despite its troubled history, Croatia’s ZIBOR has survived to this day. And it’s likely that LIBOR will do the same. However, there needs to be some realistic threat of banks being banned from participating in the LIBOR system if they provide false quotes. There also needs to be some realization that, in a tight market, not all banks will borrow at the same rate.

The real problem is the hundreds of trillions of dollars of derivatives contracts that use LIBOR – $382.3 trillion in interest rate swaps alone at the end of 2007, according to the International Swaps and Derivatives Association Inc. Just a 0.10% error on a six-month deposit, quoting 2.75% when the rate is really 2.85%, may not sound like much, but if it’s repeated over $382.3 trillion in LIBOR quotes for interest-rate-swap contracts it comes to a fair piece of change. A lot of change. To be precise, we’re talking about $194.3 billion.

Now that’s what I call an accounting error.

It looks to me like it’s a major problem. But it’s one the world will just have to live with.

And there seem to be a lot of those kinds of problems, right now.

There was more volume on the Comex on Wednesday than there had been in a while, but still nothing major. It’s interesting to note that the price rallies in both metals appeared to have been capped before the 50-day and 20-day moving averages were violated to the up-side. As I mentioned earlier this week, these are the magic moving averages that the tech funds like to use as long-side buy signals.

We also had a key reversal day to the up-side in both metals. The boys have never allowed this technical indicator to stand….squashing the price of both metals during the following trading session. Let’s see if that happens again this time. If it doesn’t, and prices continue to rise, then the tech funds will certainly show up…and the trading day could get real interesting.

As far as Tuesday’s open interest numbers, gold was up a scant 534 contracts and silver o.i. fell 761 contracts…both on very low volume. With more activity on yesterday’s strong rise in both metals, it’s pretty much a given that both o.i. numbers for Wednesday will be positive…and much larger. I’m sure there was a tech fund or two on the prowl yesterday as well.

A couple of stories today. During the last week, rice has been in the news a lot, and I have a bunch of them in my in-box. Seems like the price of rice have been climbing quite a bit…to the point where riots and strikes are breaking out in some third-world countries. Governments are becoming concerned…and some are taking action. Here’s a story out of London’s Financial Times entitled “Rice jumps as Africa joins race for supplies.” Click here.

The main feature is commentary from Michael Kosares over at usagold.com. MK puts a very positive spin on gold’s future. I’m sure his comments would encompass silver was well. The essay is entitled “Golden Gut Check” and it’s linked here.

Today should be another interesting day. Equities should continue to levitate. Now that the PPT is stalking the land, it’s hard to know what’s real and not real, as they’ve done everything in their power to thwart the pricing mechanism of our supposedly free markets. But they can’t do it forever.

The city, says Transport for London (‘TfL’) ‘is set to grow and prosper in future, with over 800,000 extra people and 900,000 extra jobs forecast over the next twenty years.’ That is certainly growth of a sort, but whether it will make the average Londoner feel any more prosperous as he fights for air in this pressing throng, I wonder. ‘Total travel is projected to increase by four million journeys every day by 2025.When the mode shift from car travel is taken into account an additional five million daily journeys will need to be supported by public transport, walking and cycling.’ This ‘mode shift’ is more likely to be the result of crawling traffic and hefty motoring charges than a genuine desire to slip into lycra cycling shorts or strap on a pair of walking boots. So, basically, five million extra bodies every day will be heading for the bus stop or tube station.

Demand for public transport is expected to increase by 40%. To anyone who has is already almost crushed to death on the tube each morning it will seem physically impossible to cope with this sort of increase. There is of course one obvious answer to the problem, and that is to do everything possible to reduce London’s population, starting with some sensible policies to move civil servants to the north of England; to build new airport capacity somewhere that could do with a bit of an economic boost – Hull for instance; and to limit immigration such that it may be possible to order a coffee in London from somebody whose first language is English.

Passenger numbers to soar

No hope of this obviously. So somehow London’s already inadequate public transport system has got to be cranked up to take 40% more passengers. This is how TfL is going to do it. ‘Improve public transport and manage the road network to reduce traffic congestion,’ i.e. more road pricing schemes, even higher parking fees and a general aim to make it impossible for the average Joe to drive from one side of London to the other. Great!

The second aim is to ‘Improve Social Inclusion.’ This section is a load of socialist gobbledy-gook, along the lines of ‘the causes of social exclusion are complex and multifaceted… solving accessibility problems can be about transport, but also about locating and delivering key activities that help people reach them.’ But basically it means step-free buses and easy-access trains for people on wheel-chairs. And it also means ‘door-to-door accessibility of trips… an essential part of improving London’s overall accessibility’, a nod in the direction of women whose night out is ruined by the prospect of the two hundred yards that they have to walk home through dimly lit and dangerous streets. What can be done about this, short of having a bus stop on every doorstep, I don’t know.

But the third objective is one that does have some meaning. TfL wants to ‘tackle climate change and enhance the environment by reducing CO2 emissions, improving air quality, reducing noise and improving the urban environment.’ No doubt this can partly be achieved by stuffing people underground onto the tube. But it can also be achieved by replacing today’s dirty fuel-guzzling buses with a new clean and fuel efficient generation.

A huge amount of work is being done on clean engines. I am not talking about fuel-cell engines which are still decades away from commercial reality. But hybrid engines, powered both the internal combustion engine and battery-generated electricity are available today, and are especially suited to the sort of stop-start journeys undertaken by buses.

Hybrid engines can make a difference to London. They could make a difference to your pocket as well, because many small companies have identified this business opportunity and are keen to benefit from it. If you want to know the best way of taking a ride on the future of the London bus, you should read the April issue of Red Hot Penny Shares.

Regards,

Tom Bulford
for The Penny Sleuth

P.S. Sign up to The Penny Sleuth absolutely FREE and you’ll be privy to my inner most thoughts, stories, projections and opinion on the UK’s most exciting share market each and every week. The Penny Sleuth bulletin goes out three times a week drawing on all my contacts, knowledge and experience from within the City. If you’re an experienced trader or simply thinking about dabbling in the markets for the first time, each issue reveals what every investor ought to know before taking the plunge. S