The Libor Scandal In Full Perspective
July 19, 2012 Original here
The article about the Libor scandal, coauthored with Nomi Prins,
received much attention, with Internet repostings, foreign translation,
and video interviews. To further clarify the situation, this article
brings to the forefront implications that might not be obvious to those
without insider experience and knowledge.
The price of Treasury bonds is supported by the Federal Reserve’s
large purchases. The Federal Reserve’s purchases are often misread as
demand arising from a “flight to quality” due to concern about the EU
sovereign debt problem and possible failure of the euro.
Another rationale used to explain the demand for Treasuries despite
their negative yield is the “flight to safety.” A 2% yield on a
Treasury bond is less of a negative interest rate than the yield of a
few basis points on a bank CD, and the US government, unlike banks, can
use its central bank to print the money to pay off its debts.
It is possible that some investors purchase Treasuries for these
reasons. However, the “safety” and “flight to quality” explanations
could not exist if interest rates were rising or were expected to rise.
The Federal Reserve prevents the rise in interest rates and decline in
bond prices, which normally result from continually issuing new debt in
enormous quantities at negative interest rates, by announcing that it
has a low interest rate policy and will purchase bonds to keep bond
prices high. Without this Fed policy, there could be no flight to
safety or quality.
It is the prospect of ever lower interest rates that causes investors
to purchase bonds that do not pay a real rate of interest. Bond
purchasers make up for the negative interest rate by the rise in price
in the bonds caused by the next round of low interest rates. As the
Federal Reserve and the banks drive down the interest rate, the issued
bonds rise in value, and their purchasers enjoy capital gains.
As the Federal Reserve and the Bank of England are themselves fixing
interest rates at historic lows in order to mask the insolvency of their
respective banking systems, they naturally do not object that the banks
themselves contribute to the success of this policy by fixing the LIbor
rate and by selling massive amounts of interest rate swaps, a way of
shorting interest rates and driving them down or preventing them from
rising.
The lower is Libor, the higher is the price or evaluations of
floating-rate debt instruments, such as CDOs, and thus the stronger the
banks’ balance sheets appear.
Does this mean that the US and UK financial systems can only be kept
afloat by fraud that harms purchasers of interest rate swaps, which
include municipalities advised by sellers of interest rate swaps, and
those with saving accounts?
The answer is yes, but the Libor scandal is only a small part of the
interest rate rigging scandal. The Federal Reserve itself has been
rigging interest rates. How else could debt issued in profusion be
bearing negative interest rates?
As villainous as they might be, Barclays bank chief executive Bob
Diamond, Jamie Dimon of JP Morgan, and Lloyd Blankfein of Goldman Sachs
are not the main villains. The main villains are former Treasury
Secretary and Goldman Sachs chairman Robert Rubin, who pushed Congress
for the repeal of the Glass-Steagall Act, and the sponsors of the
Gramm-Leach-Bliley bill, which repealed the Glass-Steagall Act.
Glass-Steagall was put in place in 1933 in order to prevent the kind of
financial excesses that produced the current ongoing financial crisis.
President Clinton’s Treasury Secretary, Robert Rubin, presented the
removal of all constraints on financial chicanery as “financial
modernization.” Taking restraints off of banks was part of the
hubristic response to “the end of history.” Capitalism had won the
struggle with socialism and communism. Vindicated capitalism no longer
needed its concessions to social welfare and regulation that capitalism
used in order to compete with socialism.
The constraints on capitalism could now be thrown off, because
markets were self-regulating as Federal Reserve chairman Alan Greenspan,
among many, declared. It was financial deregulation–the repeal of
Glass-Steagall, the removal of limits on debt leverage, the absence of
regulation of OTC derivatives, the removal of limits on speculative
positions in future markets–that caused the ongoing financial crisis. No
doubt but that JP Morgan, Goldman Sachs and others were after maximum
profits by hook or crook, but their opportunity came from the
neoconservative triumphalism of “democratic capitalism’s” historical
victory over alternative socio-politico-economic systems.
The ongoing crisis cannot be addressed without restoring the laws and
regulations that were repealed and discarded. But putting Humpty-Dumpty
back together again is an enormous task full of its own perils.
The financial concentration that deregulation fostered has left us
with broken financial institutions that are too big to fail. To
understand the fullness of the problem, consider the law suits that are
expected to be filed against the banks that fixed the Libor rate by
those who were harmed by the fraud. Some are saying that as the fraud
was known by the central banks and not reported, that the Federal
Reserve and the Bank of England should be indicted for their
participation in the fraud.
What follows is not an apology for fraud. It merely describes consequences of holding those responsible accountable.
Imagine the Federal reserve called before Congress or the Department
of Justice to answer why it did not report on the fraud perpetrated by
private banks, fraud that was supporting the Federal Reserve’s own
rigging of interest rates (and the same in the UK.)
The Federal reserve will reply: “So, you want us to let interest
rates go up? Are you prepared to come up with the money to bail out the
FDIC-insured depositors of JPMorganChase, Bank of America, Citibank,
Wells Fargo, etc.? Are you prepared for US Treasury prices to collapse,
wiping out bond funds and the remaining wealth in the US and driving up
interest rates, making the interest rate on new federal debt necessary
to finance the huge budget deficits impossible to pay, and finishing off
what is left of the real estate market? Are you prepared to take
responsibility, you who deregulated the financial system, for this
economic armageddon?
Obviously, the politicians will say NO, continue with the fraud. The
harm to people from collapse far exceeds the harm in lost interest from
fixing the low interest rates in order to forestall collapse. The
Federal Reserve will say that we are doing our best to create profits
for the banks that will permit us eventually to unwind the fraud and
return to normal. Congress will see no better alternative to this.
But the question remains: How long can the regime of negative
interest rates continue while debt explodes upward? Currently, everyone
in the US who counts and most who don’t have an interest in holding off
armageddon. No one wants to tip over the boat. If the banks are sued
for damages and lack the money to pay, the Federal Reserve can create
the money for the banks to pay.
If the collapse of the system does not result from scandals, it will
come from outside. The dollar is the world reserve currency. This means
that the dollar’s exchange value is boosted, despite the dismal
economic outlook in the US, by the fact that, as the currency for
settling international accounts, there is international demand for the
dollar. Country A settles its trade deficit with country B in dollars;
country B settles its account with country C in dollars; and so on
throughout the countries of the world.
For whatever the reason–perhaps to curtail their accumulation of
suspect dollars or to bring Washington’s power to an end–the BRICS
countries, Brazil, Russia, India, China, and South Africa, are agreeing
to settle their trade between themselves in their own currencies, thus
abandoning the use of the dollar.
According to reports, China and Japan have reached agreement to settle their trade between themselves in their own currencies.
The moves away from the dollar as the currency of international
transactions means that the dollar’s exchange value will fall as the
demand for dollars falls. Whereas the Federal Reserve can create dollars
with which to purchase the Treasury’s debt, thus preventing a fall in
bond prices, the Federal Reserve cannot prop up the dollar’s exchange
value by creating more dollars with which to purchase dollars. Dollars
would have to be taken off the foreign exchange market by purchasing
them with other currencies, but in order to have these currencies the US
would have to be running a trade surplus, not a long-term trade
deficit.
In the short-run, the Federal Reserve could arrange currency swap
agreements in which foreign central banks swap their currencies for
dollars in order to supply the Federal Reserve with currencies with
which to soak up dollars. However, only a limited number of swaps could
be negotiated before foreign central banks understood that the dollar’s
fall in value was not a temporary event that could be propped up with
currency swaps.
As the value of the dollar will fall as countries move away from its
use as reserve currency, the values of dollar-denominated assets also
will fall. The Federal Reserve, even with full cooperation from the
banking system employing every fraud technique known, cannot prevent
interest rates from rising on debt instruments denominated in a currency
whose value is falling.
Think about it this way. A person, fund, or institution owns bonds or
any debt instruments carrying a negative rate of interest, but
continues to hold the instruments because interest rates, despite the
increase in debt, are creeping down, raising bond prices and producing
capital gains in the bonds. What happens when the exchange value of the
currency in which the debt instruments are denominated falls? Can the
price of the bond stay high even though the value of the currency in
which the bond is denominated falls?
The drop in the exchange value of the currency hits the bond price in
a second way. The price of imports rise, and this pushes up prices.
The inflation measures will show higher inflation. How long will people
hold debt instruments paying negative interest rates as inflation rises?
Perhaps there are historical cases in which bond prices continue to
rise indefinitely (or even hold firm) as inflation rises, but I have
never heard of them.
As the Federal Reserve can create money, theoretically the Federal
Reserve’s prop-up schemes could continue until the Federal Reserve owns
all dollar-denominated financial assets. To cover the holes in its own
balance sheet, the Federal Reserve could just print more money.
Some suspect that the Federal Reserve, in order to forestall a
declining dollar and thus declining prices of dollar-denominated
financial instruments, is behind the sales of naked shorts every time
demand for physical bullion drives up the price of gold and silver. The
short sales–paper sales–cancel the impact on price of the increased
demand for bullion.
Some also believe that they see the Federal Reserve’s hand in the
stock market. One day stocks fall 200 points. The next day stocks rise
200 points. This up and down pattern has been ongoing for a long time.
One possible explanation is that as wary investors sell their equity
holdings, the Federal Reserve, or the “plunge protection team,” steps in
and buys.
Just as the “terrorist threat” was used to destroy the laws that
protect US civil liberty, the financial crisis has resulted in the
Federal Reserve moving far outside its charter and normal operating
behavior.
To sum up, what has happened is that irresponsible and thoughtless–in
fact, ideological–deregulation of the financial sector has caused a
financial crisis that can only be managed by fraud. Civil damages might
be paid, but to halt the fraud itself would mean the collapse of the
financial system. Those in charge of the system would prefer the
collapse to come from outside, such as from a collapse in the value of
the dollar that could be blamed on foreigners, because an outside cause
gives them something to blame other than themselves.
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