The Financial Fish Rots From the Top Down

In The Dark Knight Rises, a cruel strongman rallies the people of Gotham against the corruption of the elites, instituting a violent dictatorship in the name of a people’s liberation. What’s troubling for the viewer is that the strongman is right about the corruption. In this case, and as usual, the fix is worse than the problem.

In a similar way today, the “Occupy” protesters and populists of the left and right scream about the corruption in the system today. The ongoing Libor scandal is but the beginning.

Let’s try to understand this whole thing and see the way the corruption played itself out.

In olden days, people managing monetary and financial scams toyed with weights and measures. They would mix dross into silver to fool the traders. Governments were especially good at it, but they often relied on the cooperation of the bankers and money merchants. Everyone wins but the public.

These days, these schemes take a very different form. There is no more metal in the money, so weights don’t apply. Measures are still around, but the system has become so incredibly complicated that only a tiny elite can begin to understand it. This is one reason that the Libor scandal probably won’t stay in the headlines that long.

That’s sad, but most people don’t have the patience to understand the details. The take-away that people get from the stories is that the insiders are robbing the outsiders, and that’s hardly new. This is how the system works these days. The impression is helping to discredit the financial system even further than it already is.

The mess is being called market manipulation through price fixing. That’s not quite accurate. In a free market, it is not possible for a few producers to rig the game through conspiracy. Competitive pressure tends to bust cartels. Regardless, there are no true prices for anything as handed down from heaven. The just price is the prevailing price, whatever it happens to be, so long as no force or fraud is involved.

These days, the financial markets are anything but honest and free, and the pricing signals are no longer trustworthy indicators of economic reality. Especially since 2008, central banks and the whole network of bond dealers and large banks they deal with have been gaming the system. As Eric Fry writes, “Free markets don’t stumble around unless some government agency blindfolds them with ‘policy measures.’”

The news that’s shaken confidence even further is that the Libor was being manipulated by certain large players in cooperation with central banks and other official institutions, all of whom denied for years that there is anything odd going on.

The Libor is an average interest rate estimated by London banks, and for many years it has guided the trading policies for hundreds of thousands of institutions and trillions in wealth all over the world. The Libor gained that status from the reliability of its trading formula that takes the rates of 16 banks, slices off the four highest and lowest rates and averages the remaining ones to come up with a single composite rate that everyone used to payout formulas.

It might seem like an inauspicious target for manipulation, but that’s the whole point. The obscurity of the whole thing and the sheer complexity of the scam caused it to stay largely hidden for five-plus years after the Wall Street Journal first hinted that something was going wrong. After that first hint, the Bank for International Settlements and the Bank of England all assured traders that everything was all fabulous and there was no need to worry.

The roots the operation trace to a central bank policy of zero interest rates. This policy of zero created a world in which it is extremely difficult to make money the old-fashioned way: via lending and borrowing. The zero policies effectively broke the entire banking system and caused a massive and global scramble for other ways to fund financial and banking enterprises, especially after the previous racket of mortgage backed securities went belly up.

The Libor scandal reveals one of many ways that this is being done. The intricate plot involved very subtle and hard-to-detect changes in the way the Libor was calculated. One of the 16 banks that build the Libor would elect to defect from the middle four position within the average to join the top four in the higher-rate group. This simple step caused the average rate to tick down a notch, lowering the entire Libor payout rate that was accepted by the markets.

Why would this matter? Let’s say you are an institution among the S&P 500 that is issuing commercial paper. You are paying out to debt holders on a flexible rates and the market is determining the payout. At the same time, you are lending to Wall Street in credit swaps on a flat rate and being paid back in a flexible rate determined by the benchmark of the Libor.

This is a highly conventional arrangement that goes on every day and has for many years. In this situation, the paid and the paying forms of flexible rates are supposed to cancel each other out. If you are paying 2.5% at any given instant, you are receiving that back in your swaps.

But something strange started happening at the outset of the credit crisis. The issuing rate and the receiving rate began to diverge just slightly, not in the direction of change (it was always down, down, down), but in the rates themselves. The institution was seeing more go out than come in, and this fact alone has struck many people in the industry as strange for years. The problem was that the Libor rate being paid by Wall Street was lower than the market rate, causing billions, and even trillions, to be siphoned off in small increments of time over many years.

Is it stealing? Well, not exactly. It is more like skimming off the top, kind of like mixing your metals or changing your scales or just fixing the system in your favor. It’s true that at any point, major market players might have bailed out of using the market convention of the Libor, but remember that we are talking about huge banks here like Barclays and Deutsche Bank. The historical credibility of the benchmark and the broadness of the scheme protected it from being exposed much sooner.

Now that the cat is out of the bag, larger banks are preparing to feed individual traders to the criminal investigators, as a way of showing that the problem is traceable to a few isolated rogues, and not institutional in any way. They hope that public anger can be focused and directed against just a few, thereby containing the damage.

As Reuters says, “Regulators were looking at suspected communication among four traders who had worked at Barclays, Credit Agricole, HSBC and Deutsche Bank.” The hope is that these guys are tried and jailed, to the cheers of the masses who are out for blood, and then everyone can go back to business as usual.

In so many ways, this is really misleading. It is not believable that only a handful of traders would be engaged in manipulation in a way that so happened to massively benefit the largest players in the financial markets for more than five years, and do so at the expense of nearly every issuer of commercial paper in the entire world.

What’s more, this is a fish that has rotted from the top down, starting with central banks. As Fry has pointed out, an operation on this scale could not take place without the tacit knowledge, and probably more, of the central banks.

Moreover, such creative schemes for making a buck are directly inspired by the wrecking of the credit markets throughout the 2000s and the unwillingness of the central banks to permit the necessary rate adjustments after 2008. There is no sign that there will be a turnout in policy anytime soon. All the world’s central banks are dedicated to making it impossible to make money from lending in the conventional sense.

The old-fashioned term for the gold standard was “honest money.” Its elimination and the egregious and relentless intervention in the market by central banks have brought about a deeply dishonest financial and monetary system, one that no longer earns the trust of people in the industry itself.

It’s anyone guess what other kinds of trickery, deception, scamming and outright robbery the Fed’s nutty policies have introduced. By pretending as if powerful power have the capacity to abolish natural law (that’s what zero interest rate policies amount to), the central bankers have unleashed terrible and unpredictable things that will be headline news for many years to come.

It’s a frightening scenario. The plot of The Dark Knight Rises mirrors the history of the 20th century: Attempts by populist demagogues to clean up a corrupt system usually lead to something far worse. The Libor scandal is the perfect rallying cry for those who want to use this mess to create something far worse.

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