Is it fraud?

Just how did the banks manage to loose so much money?  Could it involve fraud, massive fraud a la Enron?  Its beginning to look very much as if it does.

Within days of the Lehman bankruptcy the market price of its bonds collapsed revealing a whopping $110bn black hole in its balance sheet just days after they were saying that a mere $10bn would fix their problem.  As a posting on the Naked Capitalism blog earlier today puts it: 

Now is there a precedent in this history of bankruptcy–excluding cases of accounting fraud–where bonds collapsed like this once a bankruptcy court opened up the books? I’m thinking the answer is ‘no.’ Which then makes you re-evaluate the premise that there wasn’t fraud at [Lehmans] in marking the value of their assets.

Now extrapolate this reasoning across the entire banking system and, voila, you have the seizure of the interbank lending market.

In general banks are quite happy to provide liquidity (in effect a bridging loan) to cover a temporary shortage of ready cash.  Proping up failed enterprises is a different matter altogether; it’s just throwing good money after bad which is why interbank lending has seized up – the banks have good reason to suspect that some of their number have liabilities that far outweigh their assets – in short that they are insolvent, the walking dead, and any loans made to them are unlikely to be repaid.  Unfortunately they don’t know which of their number are in this group.

The suspicion is that some banks have been goosing the mathematical models used to calculate the value of their sub-prime mortgages and the like.  Inevitably this involves forecasting the likely future value of a great many parameters – default rates, interest rates and so on.  Small changes in the assumption about any single one can make a huge difference to the calculated value; when many input parameters are changed simultaneously the calculated value swings wildly.

Could it be that under pressure some banks have decided that ‘in the opinion of the directors’ an optimistic view of ALL input parameters is ‘appropriate’?  You bet!  And of course GIGO.

The policy implications are clear.  There is really no point in central banks pumping vast amounts of liquidity into the system since that is not the issue.  Nor should they attempt to prop up insolvent banks.  What they need to do is identify and take down the bad banks to prevent their contagion spreading.  Then the financial system can be rebooted.

But does this amount to fraud?  Legally speaking, I don’t know – ask a lawyer.  In the court of public opinion, undoubtedly and also guilty of criminal negligence and misrepresentation.  These people have held themselves out as Masters of the Universe with salaries and bonuses to match.  If they are that good then ordinary mortals are entitled to hold them to correspondingly stellar standards of performance and integrity.

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