Unstructured Finance

Libore? The real scandal is still CDOs

July 5, 2012

By Matthew Goldstein

There is an opaque financial market where pricing is determined by a cadre of Wall Street banks and private emails show that behind the scenes  many in the market don’t even believe in what they are doing.

The Libor price fixing scandal?  Sure. But what I’m talking about here is the market for the CDOs, which at the end of the day you can still argue did more harm to the world financial system than the allegations now emerging from the Libor scandal.

Don’t get me wrong: I am not defending the apparent misconduct by bankers to manipulate Libor, a benchmark interest rate for lots of commercial and leveraged loans. But it’s still not clear just what the big harm was in the Libor scandal.

One of the allegations is that banks worked together to manipulate Libor to keep the rate low during the financial crisis. Now maybe that helped the banking system, but it no doubt helped borrowers.

And remember, almost no one pays Libor.  That’s why in loan docs it always  says Libor plus–Libor is the floor rate in any loan.

The thing is, if bankers are really going to be thrown into jail for manipulating Libor, how is it that no one goes to jail for bringing to market a financial product that arguably caused more harm to average people than anything else in recent memory?

Remember that Goldman Sachs email about one of its CDOs being “one shitty deal”?

Sure, average investors didn’t own CDOs–except indirectly through pensions funds and other investment funds they had money with. But it’s hard to argue that if not for CDOs, the housing boom and the subprime mortgage market would never have been able to grow to such heights.

Back in December 2007, when my Reuters colleague David Henry and I were still at BusinessWeek (pre-Bloomberg era) we wrote how those infamous Bear Stearns hedge funds were at the center of creating a way for money markets to to invest in CDOs that helped keep the subprime mortgage market humming along.

Now there’s nothing illegal in creating risky products to make more money for Wall Street banks and generate fat bonuses. Wall Street operates on the greater fool theory and there are no investing guarantees. But as early as 2005, I and others were beginning to sound alarms about the opacity of the CDO market and no one really understood how the deals were cobbled together or priced.

And yes, the Bear fund managers were acquitted on charges they misled their investors about the financial fitness of the hedge funds which had loaded up on tens of billions of dollars worth of CDO tranches.

But when a person in law enforcement who I respect says he wishes the feds had done more to go after the bankers responsible for bringing about the financial crisis it stops and makes you think. He said the Bear defeat scared off prosecutors but also wondered whether some just didn’t want to bring cases that would undermine the then-fragile banking system that central bankers and the Obama administration were trying to stabilize.

So here’s my question: is it easier to go after bankers involved in a scandal that at the end of the day won’t resonate much with Main Street than one that could forever rock Main Street’s confidence in Wall Street to the core?

The further we go without prosecuting anyone involved in the financial crisis, the easier it is for the populist rage against the Street to fade and for things to slowly get back to business as usual.

But prosecutions are about justice and going after the bad guys–no matter what the consequences.

Postscript: After I posted a derivatives expert I respect took some issue with my contention that the Libor scandal is sort of boring, or doesn’t have a big real real world impact. I still stand by my contention that the mess that led to CDOs is of greater importance. But this expert correctly points out that Libor has a big role in the repo market and repo was the main source of funding for CDO purchases. So, of course, there is some big linkage.

Here’s the expert:

You got the part about CDOs correct.  It was the fraudulent securitization in the shadow banking system and the leverage applied to fraudulent assets that collapsed the global financial system in the first place.  Without the money train for bad lending provided by CDOs, and without the leverage of credit derivatives that amplified the problem, the global financial system would be in much less trouble.

The LIBOR scandal is a result of this.  The end result of keeping LIBOR rates low 1) covers-up some of the above malfeasance, subsidizes wrong-doers, and covers-up for loans that would immediately default if LIBOR increased, and 2) steals from savers who get rates so low on bank CDs, treasuries and so on that the rates do not keep up with inflation on consumer staples and health care costs.

Comments anyone?

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