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.