Banks overstated their profits, and now we all get to pay

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Floyd Norris has a typically Floyd Norrisish (that is to say, really good) column in Friday’s NYT:

Consider how banks make money. They pay low rates on short-term deposits and charge higher rates on long-term loans. So they love what are known as positively sloped yield curves. And they like to see big credit spreads, where risky borrowers are charged much more than safe ones. Put them together, and banks should clean up.

By that light, nothing was going right in 2006 and early this year. The yield curve was inverted, or at best flat. And credit spreads were at historic lows. Risky loans, whether to subprime mortgage borrowers or junk-rated corporations, were readily available at rates that seemed to assume there was only the slightest risk of default.

And yet the bank stocks were buoyant, and so were reported profits.

Floyd’s point is that much of this reported profit is turning out to be bogus, the result of banks failing to account for the silly risks they were taking. Which made me think of a chart I put together for my Citigroup article last week. It was in the magazine, but not online. So here it is:

The financial sector, in the BEA’s reckoning, includes banks, insurance companies, securities firms, and much of the real estate business. I don’t think that most of its spectacular gain in profitability between 2000 and this year was bogus. I do think it has proved to be unsustainable.

Which brings me to the end of Floyd’s column:

The most important duty of the Federal Reserve is to preserve the health of the banking system. In the early 1990s, after the last big crisis, it engineered a steep yield curve for years, helping banks to recover. When the smoke clears, the Fed will try to do that again, even if it means significantly higher long-term interest rates.

Higher long-term rates are not what either debt-laden consumers or the depressed housing market really need, of course. But such trade-offs are what come when big risks are taken, and ignored, for too long.