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The Fine Line Between Incompetence and Criminality

Nothing is more important to the functioning of a free market than commercial banks with a degree of flexibility in taking risk. If banks had foreclosed on every home mortgage that missed a couple of payments after the 2008 crisis, we would be in a Great Depression. The same is true if banks called in the loans of every corporate borrower who violated a covenant. Mark Twain defined a gold mine as a hole in the ground with a bunch of liars standing around it, and in tough times, bank balance sheets are a tissue of white lies -- otherwise known as giving borrowers the benefit of the doubt. What if banks cross the line into actual criminal behavior, though? On top of the LIBOR scandal, we have a new report from the New York Times claiming that big investment banks gave an illegal advance look at research reports to their biggest hedge fund clients.

In an election year, the liberal media will incite witch hunts against the financial industry in order to bias voters against financiers who made their money honestly -- Mitt Romney, for example. I am deeply suspicious of the Justice Department's motives in criminalizing the LIBOR problem. But where there are instances of real criminality they need to be prosecuted.

There are white lies and (possibly) criminal lies involved in the LIBOR scandal. This looks like a matter for civil courts. The biggest lie was to underreport the actual cost of funds when the truth would have revealed prospective difficulties in funding and contributed to panic. I wrote this morning in Asia Times ("The LIBORatory of Dr. Frankenstein"):

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.

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. 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.