The US Justice Department plans
to bring criminal charges against banks for
manipulating the benchmark rate for US dollar
money markets, the London Interbank Offered Rate
(LIBOR). It would be the first prosecution of
financial institutions for having charged their
customers less rather than more, and having taken
less rather than more income.
That's
right: rigging LIBOR transferred income away from
the banks to their debtors. There is a case for a
civil suit by shareholders for income lost to the
banks' largesse, but hardly a criminal case.
Attorney General Eric Holder, the man who
arranged former US president Bill Clinton's pardon
of fugitive tax cheat Marc Rich, fresh from
condemnation for contempt of Congress by the House
of Representatives, is
shocked - shocked - to find that interest rates
went misreported at the peak of the financial
panic of 2008. Criminalizing the kind of
rule-bending that the regulators sanctioned during
a crisis is sadly typical of the Barack Obama
administration's operating procedure.
Meanwhile, the liberal punditeska from The
Economist (with its "Banksters" cover last week)
to the Washington Post call for prosecution of the
banks. Holder and his colleagues see the economy
as an experimental subject for a sort of
Frankenstein's laboratory. No wonder that
investors are keeping their cash in mattresses
rather than investing it the kind of risk ventures
that create jobs.
After the August 2008
Lehman Brothers collapse, money markets froze, and
large global institutions paid a risk premium to
borrow money. The volume of interbank loans
contracted by a quarter, and the concept of a
uniform LIBOR rate dissolved as banks charged each
other as much as they could get.
Total International Claims of
Banks in BIS Reporting Area Source: Bank for
International Settlements
If this
situation had persisted, the world financial
system would have shut down and economic activity
would have ground to a complete halt. Central
banks and finance ministries did the right thing:
they lied, not just about the LIBOR rate but about
the solvency of the banking system. A New York
Federal Reserve memorandum released to the press
on July 13 quotes an employee of Barclays stating
clearly that the bank had misreported its own cost
of funds. The New York Fed circulated this
information to the Fed offices in Washington and
the US Treasury. Everyone in government knew. So
did everyone in the market.
Underreporting
the cost of funds (in order to pre-empt possible
panic about the condition of the banks) was the
least interesting lie the regulators sanctioned.
The biggest lie involved the solvency of the banks
themselves. Banks had bought upwards of US$1
trillion of so-called AAA bonds issued against
subprime home mortgages, and levered them in
off-balance-sheet gimmicks by 70 to 1 (that is,
banks held only $1 of capital for $70 of
outstanding bonds). The value of these bonds fell
by more than half as the housing market collapsed.
If the banks had marked these bonds to
market, as prevailing account rules required, they
would have been insolvent (their shareholders'
capital would not have sufficed to meet their
losses). Radical voices like Paul Krugman at the
New York Times (whose Nobel Prize in economics had
nothing to do with his political opinions)
demanded nationalization of the banks.
As
I observed at the time, though, the banks may have
been insolvent, but they were still earning enough
interest income from their portfolios of AAA-rated
trash to pay their interest costs. There was no
reason to wind up their affairs; ignore the
technical insolvency and focus on current cash
flow, I argued, and the system would return to
health. That was a much bigger lie than the rigged
LIBOR rate, but it wasn't the biggest lie. The
real whopper was the pretense that tens of
millions of homeowners could and would pay their
mortgages. Banks delayed foreclosure and kept
families in their homes for months and years past
the usual cutoff date for seizure. That was also
the right thing to do.
This tissue of
lies, collective referred to as "regulatory
forbearance", allowed the banks to get their
balance sheets under control within a year, repay
emergency loans to the US Treasury with a profit,
and get back to the business of lending.
American banks (unlike their
sovereign-saddled European peers) are contributing
to economic growth, such as it is. Loans to
businesses (commercial and industrial loans) at
large reporting banks are growing at a 17%
year-on-year rate, just about the highest in
history.
Commercial and Industrial
Loans Are Growing at Large US Banks Source: St Louis Fed
Banks are
limping back to profitability. Not that they are
doing especially well; the KBW Banking Index has
lost 60% over the past five years, while the broad
stock market has lost just 10%. But they are still
in business and lending to businesses.
The
lies did the trick. The truth won't set you free;
the truth will make you broke. The regulators did
this before, in 1982, when the bankruptcy of some
big emerging market debtors ruined the solvency of
big American banks that had lent them too much,
and again in 1990, when a real estate market
collapse left a number of institutions (notably
Citibank) in technical insolvency. That's what
regulators are supposed to do. If you want
Inspector Javert to run the Federal Reserve,
prepare to be very, very poor.
There are
flagrantly incompetent numbers floating about in
the financial press, for example, that $800
trillion of financial instruments are pegged to
LIBOR (that's about 10 times the net worth of
Europeans and Americans combined!). The $800
trillion number comes about through double
counting (I write you a check for $100, and you
write me a check for $100, so there are $200 in
checks outstanding). There's one important thing
to know: manipulating the LIBOR rate downward
meant less income for the banks, and lower
interest payments for homeowners with
adjustable-rate mortgages.
A lot of poorly
informed opinion has been published about the
LIBOR scandal, including any an allegation of a
"deeper, darker" scandal by two old friends of
mine, Paul Craig Robert, who drafted the Reagan
tax cuts as an aide to then Congressman Jack Kemp,
and Nomi Prins, my colleague at Bear, Stearns'
quant research group two decades ago. They claim
that the LIBOR scandal as played in the press is
"a diversion from the deeper, darker scandal".
They write:
One could argue that by fixing the
rate low, the banks were cheating themselves out
of interest income, because the effect of the
low LIBOR rate is to lower the interest rate on
customer loans, such as variable rate mortgages
that banks possess in their portfolios. But the
banks did not fix the LIBOR rate with their
customers in mind. Instead, the fixed LIBOR rate
enabled them to improve their balance sheets, as
well as help to perpetuate the regime of low
interest rates. The last thing the banks want is
a rise in interest rates that would drive down
the values of their holdings and reveal large
losses masked by rigged interest
rates.
This is simply incorrect. LIBOR
is the main benchmark rate for floating-rate bonds
(whose interest changes when short-term rates
change); such debt has very little interest
sensitivity. Rising short rates would not "drive
down the value of [bank] holdings". If anything,
the price of floating-rate assets tends to rise
when the absolute level of rates goes up, although
the effect usually is small.
The main
beneficiaries of LIBOR rigging were homeowners
with adjustable rate mortgages pegged to LIBOR (as
are the vast majority of such mortgages), who paid
lower rates than they should have. If anything,
the banks acted as inadvertent Robin Hoods,
reducing their own interest income while lowering
interest costs for homeowners. The only benefit
they derived from misreporting LIBOR rates was
psychological. It saved them from admitting that
the market demanded a risk premium to lend them
short-term money. But they still had to pay the
higher rates on deposits. They weren't able to
collect correspondingly higher interest rates on
their portfolio.
I'm all for putting
bankers in jail for bad behavior, and I am
disappointed that the prisons aren't full of them.
Banks lied about liars' loans in the subprime
market, shoveling through loan applications that
obviously failed to meet their own standards, and
in one documented case - namely Citigroup -
persecuted senior executives who warned against
the practice. If someone wanted to call that
criminal fraud, I would be interested to see if a
case could be built. The ratings agencies gave an
AAA stamp to subprime garbage and knew that they
were selling their souls, as an Stamdard &
Poor's official stated in an email uncovered by
congressional investigators.
There might
be a case for fraud in such matters. I do not know
whether fraud occurred, but it would be worth some
effort to find out. The LIBOR matter also was
fraudulent in a sense, but it was integral to a
bigger, and benign, deception on the part of
regulators, whose biggest beneficiary was
homeowners. To prosecute this, rather than a dozen
acts that resemble real crimes, suggests
grandstanding in front of a presidential election
rather than the pursuit of justice.
Spengler is channeled by David P
Goldman. His bookHow
Civilizations Die (and why Islam is Dying,
Too) was published by Regnery Press in
September 2011. A volume of his essays on culture,
religion and economics,It's
Not the End of the World - It's Just the End of
You, also appeared last autumn, from Van
Praag Press. Goldman was global head of fixed
income research at Bank of America 2002-2005 and
head of Credit Strategy at Credit Suisse
1998-2002.
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