8
Moral hazard in the system
The process by which banks create money is so simple the mind is repelled.
J.K. Galbraith, economist
One of the chief ways in which investors fall victim to fraud is that they misperceive the risks of a given investment – often with a little help from the people selling that investment! Prestidigitation is rife in the markets, as financial services firms do their best to make their offerings seem as attractive as possible. As we have seen, investors suffer from what economists call the ‘principal–agent problem’, where the investor is the principal and the financial service provider is the agent. The agent has better information about the market than the principal and the principal cannot closely supervise what the agent is up to. This provides agents with an incentive to put their own interests above those of the principal – so investors must rely on financial regulation to protect them. The principal–agent problem is an example of the issue known as ‘moral hazard’, which is where one party takes risks but another party suffers the consequences if things go wrong. Moral hazard occurs in many areas, not just in investment. For example, a night watchman who sleeps on the job is a moral hazard for his employer, who will bear the consequences if thieves break in. Moral hazard often occurs in situations where employees are difficult to fire, as in the public sector. In investment, misselling a product to investors and paying huge bonuses to financial professionals out of investors’ funds are typical examples of moral hazard.
Moral hazard cannot be eliminated entirely from the system, but it can be kept within manageable limits by carefully designing the way financial institutions are structured, developing workable rules, and establishing effective financial regulators who have the power to punish. In the last two decades moral hazard has greatly increased during a period of massive global expansion of financial services and overly lax government policies, particularly in the US, which remains the dominant player in finance. These overly lax policies came about partly by accident, partly, it seems, through corruption, and partly because some governments appear to have been dazzled by the increased tax revenue they were able to raise from the financial services industry during the ‘noughties’. It is worth pointing out that in spite of the rhetoric about free markets during the boom years, financial services can never really be entirely free: governments have to participate in financial markets in many ways on many levels, and the key industry in finance – which is banking – cannot, in the opinion of most economists, be left to operate uncontrolled. Since the series of financial crises that began in 2007/8, many earlier warnings by ‘Cassandras’ about the dangers of systemic moral hazard within banking are now proving to have been correct.
Many people think that a ‘Cassandra’ is just a pessimistic naysayer (what the Americans call a ‘Gloomy Gus’) but in ancient Greek legend Cassandra was cursed by the gods with the gift of accurate prophecy. It was a curse because the gods had ensured that Cassandra’s true prophecies would never be believed. Recently a naïve commentator in the Guardian newspaper opined, the ‘notion that the entire global financial system is riddled with systemic fraud – and that key players in the gatekeeper roles, both in finance and in government, including regulatory bodies, know it and choose to quietly sustain this reality – is one that would have only recently seemed like the frenzied hypothesis of tinhat-wearers’. Nothing could be further from the truth, as anybody with some direct experience of financial markets has always known. Now some of the cats are out of the bag, however, the problems are endlessly discussed in the mainstream media that had hitherto largely ignored them.
As the eminent Financial Times journalist Martin Wolf has pointed out, ‘a financial sector that generates vast rewards for insiders and repeated crises for hundreds of millions of innocent bystanders is ... politically unacceptable in the long run. Those who want market-led globalisation to prosper will recognise that this is its Achilles heel’. As a private investor who does want market-led globalisation to prosper, I do indeed recognise this weakness; however, there is also the danger of overdoing the backlash and returning to the dreary Cold War era when too many restrictions on investment and finance severely limited economic prosperity in many parts of the world.
In October 2009 the Governor of the Bank of England, Mervyn King, gave a speech in which he discussed the part played by the banking industry in the financial crises, and the need for major reforms. King argued that ‘banks increased both the size and leverage of their balance sheets to levels that threatened stability of the system as a whole’ and then relied on governments to bail them out. This is, of course, a kind of moral hazard. If I own a bank that I know the government will not allow to fail, I have a big incentive to take wild risks, knowing the government will pay if my wild risks go wrong. According to King, ‘banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.’
While government intervention may sometimes be necessary in the short term during a crisis just to keep the system from collapsing, such support cannot be sustained indefinitely. King went on to argue that there are two ways to deal with the problem: either you can create a special category of ‘too big to fail’ banks and regulate the hell out of them, or you can find ways of allowing banks to fail while protecting ordinary people’s savings, mortgages, rates and so on.
Back in the days of stiffer regulation, prior to the ‘Big Bang’ of financial deregulation in the 1980s, financial services were kept strictly separate – you could not, for instance, be a high street bank, a stock broker, a derivatives trader, a fund manager, a bond issuer, a financial adviser, a mortgage provider and an investment bank all at the same time. You can now. When deregulation first occurred, we were assured that there would be no conflicts of interest between all the different financial activities large institutions could now take on. We were told that a clever system of ‘Chinese Walls’ within the institutions would prevent this. This very quickly proved not to be true as illustrated by the Dennis Levine story (see Chapter 2), and the conflicts of interest within the banking system have continually grown since then.
Moral hazard within the banking system now amounts in many cases to outright fraud, but because this is institutionalised and ubiquitous it has been difficult to assign blame. When the banking scandals first began to come to light in 2007/8, it looked as if many institutions and individuals were going to get off scot-free. However, in the ensuing years, as more and more evidence of wrongdoing by banks has emerged, it has become probable that at least some of them are not going to be allowed to get away with it. To understand the scale and depth of the problems in the banking system, we’ll look at two examples: the ongoing LIBOR scandal, and a severe case of corruption and ‘misselling’ (that’s what some people might call ‘cheating’) in small-town USA.
The LIBOR scandal
The London Interbank Offered Rate (LIBOR) is a collection of interest rates for major currencies and time periods that are used as reference rates for a wide range of financial transactions. LIBOR rates are calculated every morning of every banking day, and are based on an average of the rates a range of banks, known as ‘panel banks’ say they would have to pay if they borrowed from another bank on that day in a specific currency for a specific (short-term) time period. The data are submitted at 11.10 a.m. and then published by Thomson Reuters at 11.30 a.m. each day. In order to prevent manipulation, the upper and lower quartiles of the data submitted by panel banks are ignored, and the rate is based on the middle two quartiles of the data. LIBOR rates are very important benchmarks for transactions around the world, especially for derivatives deals (at least $350 trillion in derivatives are linked to LIBOR) that are sensitive to small changes in the rate. LIBOR was set up in the 1980s to ensure that rates on corporate lending did not fall below the rates at which banks were lending to each other.
In June 2012 the UK’s Financial Services Authority (FSA) fined Barclays Bank £59.5 million for acting ‘inappropriately’ on occasion between 2005 and 2008 by allowing its submission to Thomson Reuters to be influenced by the demands of its own derivatives traders, and traders at other banks. The FSA also found that Barclays had tried to influence the submissions of other banks relating to US dollar LIBOR and EURIBOR (a similar benchmark based on euros), and had also made ‘inappropriate LIBOR submissions to avoid negative media comment’ between 2007 and 2009 during the banking crisis. In its notice to Barclays about the fine, the FSA quotes extensively from emails and conversations between traders and those responsible for submitting the rates each day that demonstrate a conscious desire to manipulate the rates. For example, ‘on 8 October 2008, a Submitter was asked about Barclays’ LIBOR submissions during a telephone conversation. He responded that “[Manager E]’s asked me to put it lower than it was yesterday … to send the message that we’re not in the shit”.’
In the same month, Barclays was fined $160 million by the US Justice Department and $200 million by the US Commodities Futures Trading Commission in relation to this ‘inappropriate’ behaviour, which the American agencies, in contrast to the mealy-mouthed FSA, robustly termed ‘manipulation’. The bank’s Chairman, Philip Agius, and CEO, Bob Diamond, both promptly resigned. It has been open season on banks since the financial crisis began in 2007/8, and the media around the world have had a field day.
At the time of writing, at least ten more regulators round the world are looking into possible wrongdoing by the panel banks that help set LIBOR. It had already been plain that Barclays had not been the only bank up to no good, and it did not come as an enormous surprise in December 2012 when the Swiss bank UBS was fined $1.2 billion by the US Justice Department and the Commodities Futures Trading Commission, 60 million Swiss francs by the Swiss regulators and £160 million by the FSA for its role in the affair. UBS had been caught with more than 2,000 documented instances of its employees conspiring to manipulate LIBOR rates between 2005 and 2010 with a recklessness and arrogance that beggars belief. They knew that their phone conversations were recorded and their emails were kept, but in many cases they openly discussed their wrongdoing. Even the Mafia talk in code! It also emerged that not only banks, but interbroker dealers (who are intermediaries between banks) were also involved.
In 2013, the Royal Bank of Scotland was fined £390 million and it is very likely that many other banks will follow. In the US, a torrent of lawsuits has been unleashed by corporations and municipalities who claim to have been forced to overpay on their borrowings because of the manipulation of LIBOR rates. Regulators around the world seem at last to be prepared to act in concert to curb the arrogant cynicism of the banks. Better still, it appears that regulators may move against banks for the widespread misselling of interest rate swaps (see Jefferson County below).
Well, let’s not get too excited. By the time you read this, the LIBOR affair may be ancient history. Some bankers may even have been sent to prison, but banks will still be here. We can’t function without them. And no amount of regulation will prevent them from acting, in the FSA’s immortal understatement, ‘inappropriately’ if the opportunity appears.
The swindling of Jefferson County, Alabama
In 1996, following lawsuits by the US Environmental Protection Agency and others, a court ordered Jefferson County, the most heavily populated county in Alabama, to renovate and expand its sewer system to prevent sewage overflows into a number of rivers. The County duly began to raise money for this purpose, and between 1997 and late 2002 it issued a succession of warrants (a type of bond) paying fixed rates of interest. Although critics complained that the project was unnecessarily ambitious, original estimates of the cost of the sewer project were around $250 million, a tiny fraction of the debt that Jefferson County eventually incurred. As with most public projects, costs began to escalate as suppliers sought to pump up their share of this lucrative scheme. Charles LeCroy, then at the financial services firm Raymond James, arranged most of the fixed-interest warrants. Then, in 2002, LeCroy went to work for the regional office of JPMorgan Chase, the investment bank, and brought a lot of his municipal customers with him.
LeCroy set up a deal with William Blount, a local business consultant, to persuade Jefferson County to refinance their borrowings for the sewage project. Between late 2002 and late 2003, Jefferson County issued three new bond offerings at variable rates of interest, raising approximately $3 billion – considerably more than the original estimate of $250 million for the sewage scheme – which were arranged and underwritten by JPMorgan Chase. These arrangements had the effect of changing the County’s bond debts from sensible and predictable fixed interest rates to not very sensible and considerably riskier variable interest rates. The variable rate offered the dubious benefit of lower interest payments in the short term, together with the likelihood that they would rise substantially in the future. They also generated millions of dollars in fees, not only for JPMorgan and William Blount’s firm, Blount Parrish, but also for a range of other local outfits associated with County commissioners.
Worse was to come: during the same period Jefferson County also entered into a number of interest rate swap agreements with a total notional value of $5.6 billion, mostly with JPMorgan. An interest rate swap is a derivative contract where two parties agree to swap interest payments on specific sums for an agreed time period. The purpose of the interest rate swaps was supposed to be to ‘fix’ the interest payments the County would be making on the variable rate bonds it had just issued. Like the refinanced bonds, the interest rate swaps also generated large fees for JPMorgan and Blount Parrish, and, according to the prosecution in a court case against JPMorgan and others, ‘the price the county paid for these transactions in terms of fees and interest rates was artificially inflated by millions of dollars, to account in part for the fact that JPMorgan’s scheme to secure the county’s business included bribes, kickbacks and pay-offs the Defendants paid to or received from each other.’ It is estimated that Jefferson County was overcharged by as much as $100 million on the swaps.
According to the complaint in another court case brought by the SEC in 2009 against LeCroy and Douglas McFaddin, another JPMorgan executive, early in 2002, LeCroy had corresponded with his superiors at JPMorgan to propose that the bank pay bribes to two small local stock broking firms to get them to influence Jefferson County commissioners to give the sewer bond business to JPMorgan. LeCroy suggested that such payments would be modest – $5,000 to $25,000 per deal – and received a positive response from one of his bosses. According to the SEC, as the sales drive progressed many payments were made to more local people, totalling millions of dollars. In mid-2002 LeCroy and McFaddin targeted two County commissioners who had lost their elections and were due to leave office in November, and who wished to see the two small local stockbroking firms receive their backhanders from JPMorgan. A taped conversation between LeCroy and McFaddin was presented as evidence, showing that the two executives had discussed how to redraft an invoice from one of the stockbrokers to ‘conceal the firm’s lack of participation in the transaction’.
In November 2002 Larry Langford, a long-time friend of William Blount, became head of the Jefferson County Commission. Blount urged Langford to do a swap with Goldman Sachs, not JPMorgan, because his firm had a consulting arrangement with Goldman. Blount arranged loans and cash payments for Langford and bought him expensive designer clothing as an inducement to keep Blount Parrish involved in the bond and swap deals. LeCroy and McFaddin negotiated with Langford to pay Goldman millions to stay out of the deals – and Blount Parrish received $2.5 million from JPMorgan’s profits. These payments were disguised; in the case of the Goldman pay-off, JPMorgan created a fictitious swap contract to transfer the money. From then on, every time the County did a bond or swap deal with JPMorgan, Langford and Blount received hefty payments, as well as other commissioners and associates, and a few Wall Street firms.
The litany of the bribes paid goes on and on. It makes appalling reading, but it should not distract us from the even more outrageous fact that Jefferson County wound up borrowing $3 billion through issuing bonds, and had been persuaded to enter into very risky interest rate swaps that it did not need. Through the petty greed of local officials and businesspeople, and the ruthlessness of JPMorgan, the County had made itself hostage to massive liabilities that would eventually go very wrong indeed.
In the meantime, however, there was trouble brewing in the construction end of the sewer project. A 2003 engineering report found that there was massive waste and little coordination of the programme, and estimated that there was up to $100 million in ‘accounting discrepancies’ between relevant County departments. In 2005 the FBI indicted 21 County officials, commissioners and contractors, the majority of whom have been convicted of bribery and received large fines and short prison terms. In 2006, the SEC began to investigate the County’s bond and swap deals.
Then, in 2007, came the US housing crash. Early in 2008 the County’s insurers had their ratings downgraded, forcing up interest payments, and the County’s own credit status was downgraded to junk by Standard & Poor’s. These events triggered penalties in its swap deals, so now it had to pay off in excess of $800 million in four years, rather than the forty years originally agreed. Underwriting banks were forced to take up unsold bonds, for which they imposed large penalties. In 2009, the cost of servicing Jefferson County’s debts had risen to $636 million, from $53 million in the previous year. There was also a problem with the interest rate swaps themselves; JPMorgan was paying the County a low rate based on LIBOR, while the County had to pay its bondholders a much higher rate. Jefferson County began to default on its interest payments.
In 2009 Larry Langford, who had risen to become Mayor in 2007, was convicted of receiving bribes worth more than $200,000 in relation to the sewer financing and was eventually sentenced to 15 years in prison. Blount, the fixer, received fines and a sentence of more than four years. JPMorgan paid the SEC a fine of $25 million, returned $50 million to Jefferson County, and was forced to abandon its demand for $647 million in termination fees from the County. LeCroy, who had been fired by JPMorgan in 2004 over an unrelated matter, is still being pursued in court by the SEC at the time of writing.
For Jefferson County, all this retribution has been too little, too late. In 2011 it declared bankruptcy. Water rates have shot through the roof, courthouses are being closed down and schools starved of essential funds – and all because some bent local politicians were outwitted by the outrageous predatory practices of Wall Street firms.
Surviving the banks
Top bankers are powerful and often have a great deal of influence on politicians, which may be one reason why so few senior bankers have gone to jail, and why efforts to reform the banking system have been so slow to have any effect. There have clearly been many rearguard actions by the banks to defend themselves against attempts to make them change the way they operate. For example, in the UK there have been repeated threats by major banks to leave the country if reforms are too harsh. In the eurozone, continental banks lent heavily to the wrong people (for example the Greek government) in the belief that the political will to make the Eurozone work would ensure the banks would be bailed out if the loans went bad. They may yet be proved right, as European politicians appear unwilling to face up to the economic chaos that they have helped to create by pursuing a grandiose ideology of EU integration while ignoring economic realities. In the US there are signs of a new determination to deal more harshly with the excesses of predatory financial institutions. The case for breaking up the large banks and separating the utilitarian banking functions, such as high street banking, completely from riskier activities such as investment banking seems very strong, as it would help to protect the real economy from the excesses bankers have committed in the financial markets. But such a profound restructuring of the industry would require a concerted effort by governments around the world and very widespread political support. In spite of enormous public outrage at bankers’ behaviour during the ‘noughties’, there has not yet been any strong move to break the grotesque bonus culture in the sector, which has plainly increased moral hazard and cannot be justified on the grounds of attracting talent. Excessive bonuses have incentivised finance professionals not only to take excessive risks but also to flout the rules that were designed to keep the system stable; if this is allowed to continue, we can expect to see another large crisis in the sector within a decade or two.