We should have known something was strange. The banks were doing a lot better than they should have been doing.

When the history of the financial excesses of this decade is written, that will be a verdict of financial historians. There were signs that banks were either lying about their results or were taking large risks that were not fully disclosed, but investors were oblivious.

What were the signs? 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.

“We should have been suspicious from the get-go,” said Robert A. Barbera, the chief economist of ITG. “There was financial alchemy at work.”

Read it all.

Filed under: * Economics, Politics • Economy

1. RickW wrote: Having read this article, the article referenced from Fortune and looked at the company’s annual report and SEC statements from 2006, it seems that this is another Enron situation and the auditor, KPMG, let some fishy accounting happen. The action of selling off loans that they are then forced to take back is the same as booking sales that are not truly sales, which is a big no no - which is also what caused the Enron failure. Rubin is being played as the hero coming to rescue, but while all of this was happening, he was being paid $17 million a year and not paying attention to what was happening. November 18, 5:15 pm | [comment link]

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