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Home Publications Blogs Beat the Press Why the Wall Street Perps Walked

Why the Wall Street Perps Walked

Friday, 13 September 2013 04:02

Neil Irwin had a discussion of the failure to prosecute any of the Wall Street honchos for the conduct that led up to the financial crisis. He concludes that:

"America doesn’t criminalize bad business decisions, even when they lead to business failure."

That is obviously true, but this is not the issue. The Financial Crisis Inquiry Commission (FCIC) found:

"Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop.

"And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this critical information was not disclosed."

The question was not whether the top executives of mortgage issuers like Countrywide and investment banks like Goldman Sachs bought into the housing bubble, the question is whether they followed proper business practices in their lust to cash in. The assessment of the FCIC is that they did not. Issuing a mortgage that is known to be based on false information and then selling it in the secondary market is fraud and punishable by time in jail. Similarly, packaging loans into mortgage backed securities that an investment bank has good reason to believe are based on false information is also fraud and punishable by time in jail. (It's actually common for true believers in a bubble to also commit fraud. It is likely top executives at Enron believed that they were actually running a profitable company.)

The way prosecutors would construct a case to prosecute top executives would be by starting at the bottom. They would have gone to branch offices at major subprime issuers like Countrywide and Ameriquest and find out why mortgage agents were issuing so many mortgages with improper documentation. Since this was done by many agents, they presumably could have gotten one or more to report that this was a policy of the branch manager. Presumably branch managers told agents that they needed to issue certain numbers of mortgages and they did not care if the mortgages did not meet proper standards.

Prosecutors would then ask branch managers why they thought it was clever to tell their agents to issue mortgages without proper documentation. Since many branches engaged in these practices, presumably this was the policy of the company. This should have led to prosecutions at the main offices of these subprime issuers, if not the very top executives.

Serious efforts at prosecuting the investment banks would follow the same process. The people who put together some of the worst mortgage backed securities would be asked if they were really dumber than rocks and had no idea that many of the mortgages being put into the packages were fraudulent. If the prosecutors could demonstrate evidence of intelligent life at Goldman Sachs and Morgan Stanley they would then ask the lower level people whether they wanted to spend years in jail or would rather explain why they thought it was a good idea to put tens of millions of dollars of fraudulent mortgages into mortgage backed securities. This would presumably lead to testimony against higher ups at these investment banks.

There would be a similar process at the bond rating agencies. In the case of Standard & Poors, there was actually a famous e-mail in which one auditor complained that they would rate an issue as investment grade if it was structured by cows. A serious effort at prosecution would ask these auditors how they came to believe that it was their job to rate issues structured by cows as investment grade.

There is no guarantee that these sorts of efforts would have landed top executives of financial firms behind bars. However there is no evidence that the Justice Department even began this sort of investigation. At the least, such an investigation would have resulted in prosecutions of lower level actors who clearly violated the law in issuing and passing on fraudulent mortgages. 

As Irwin said, bad business judgment is not a crime. However, it is a crime to allow bad business judgment to lead to fraud. Clearly fraudulent mortgages were a major factor in propping up the housing bubble. No one went to jail for this crime.

Comments (19)Add Comment
The Perps Walked Because of Big Government, Not Fraud in the Private Sector, Low-rated comment [Show]
Fannie Fraud
written by Robert Salzberg, September 13, 2013 6:18
One easy place to find and prosecute fraud was when the liar loans were sold to Fannie knowing they didn't meet conforming standards. There was also a robo-signing lawsuit which was really low hanging prosecutorial fruit. The banks have paid a wrist slapping fine with no real attempt at criminal prosecution.
the deserving and undeserving
written by Jennifer, September 13, 2013 7:40
It really is amazing, with the extensive evidence out there, that there was no sustained effort at prosecution. There is no mention of Sarbanes-Oxley in that piece, which surely must have applied somewhere. Also lacking in that piece was any recognition of the many homeowners who were illegally kicked out of their homes, because of banks mistakes or malice. It's particularly galling in light of the push to eliminate the "fraud" in food stamps-which basically consists of additional requirements making the process more difficult and will probably not even save money. Poor people need to be punished, but the "important" people, well they just carry on.
..., Low-rated comment [Show]
We get the system we deserve
written by Sustainable Gains, September 13, 2013 10:13
Unless and until the people of the nation say "enough" and actually fight for their rights, all of this abuse will continue.

@skeptonomist - if there was sufficient political will to impose the necessary reforms, there would also be sufficient political will to rein in the excesses. I would also argue that until you put the perps behind bars any attempt at reform will be scoffed at and ignored.

Next time you vote -- either in a ballot booth, with your wallet, or with your feet -- don't reward those who betrayed America for their own personal profit.
written by James, September 13, 2013 11:03
On one hand I agree that trying to prosecute these crooks is a waste of time. But by not attempting to prosecute these crooks you end up confirming the status quo message that the only crime worth pursuing is that committed by the “little people.” If the rule of law is gone in the US, let's admit it. But I think most people still assume that it should be in effect. We imprison more poor people right now for cocaine possession and bounced checks. If those crimes are worthy of punishment, then committing fraud that leads to banks collapsing (and which need taxpayer bailouts) is wrong too.
Fed and short/long term interests
written by Ernie Bornheimer, September 13, 2013 11:35
skeptonomist said: "There needs to be immediate oversight of the type of transaction which leads to systemic risk, and this can't be done in a discretionary way by people (the Fed) who have an interest in the immediate booming of the economy."

This sounds interesting. I wonder if you have any sources on how the Fed only has a short term interest in booms, at the expense of the longer-term health of the economy?
written by urban legend, September 13, 2013 11:48
Skeptonomist seems to think the Justice Department can't do its thing at the same time the SEC and other financial regulatory authorities do theirs. Under what possible theory is prosecuting executives guilty of fraud a diversion, much less a waste of time? Making crime not pay -- clawing back ill-gotten bonuses and half of the Hamptons, for example -- is a waste of time? Showing that the system will punish wealthy wrongdoers as well as the little guys with some marijuana is a waste of time?
written by urban legend, September 13, 2013 11:56
Nothing damaged the Obama legacy more than this. It seems Obama and his team had to guarantee his re-election (and post-Presidency foundation) by assuring the continual flow of Wall Street money. He had a willing accomplice at Justice with an Attorney General who made sure his own transition to a leadership role in the private sector legal community would be smooth.

I assume they would bristle at this, but it sure looks like outright corruption from here. Prove it isn't. The burden of proof is on them.
written by watermelonpunch, September 13, 2013 12:39
Oooh... could this possibly also deter immigration? Because if so, we have a shot at getting my rep on board.
(I live in Pennsylvania's 11th congressional district.)
written by Jay, September 13, 2013 4:32
Financial crimes divisions are under funded. You probably have a handful of prosecutors that are skilled enough to pull off these cases and they probably don't have the investigative team to accomplish much. This is why it is important to fund law enforcement and have people without conflicts or a desire to move into defense after handling one big case. Then you have to deal with legislative consequences for taking action.
written by watermelonpunch, September 13, 2013 5:14
disregard my comment here I posted in wrong thread *^^*
written by Jim Forrester, September 14, 2013 10:24
The Administration's excuse for not prosecuting these crooks is probably the same they've used for a lot of the things not done: Go after these guys and confidence will be lost in the banks and the economy will tank.

I don't buy it for a minute and agree that the hidden motives described in other comments are closer to the real reasons.

Going after these guys is a waste of time only if you're not serious about putting them away. Give some guys named Lloyd and Angelo ten years of hard time and I believe the economy will have received some of the recovery tonic it needs.
White collar crime
written by Dwight Snider, September 14, 2013 5:48
Steal a little and they throw you in jail
Steal a lot and they make you king
- Bob Dylan "Sweetheart Like You"

The problem is not whodunit. We know who did it.
The problem is FBI attorneys having to prove to a naive jury, against the forces of a very savvy and very well-funded legal corps, that what was done was a crime.
prosecutions would unravel derivatives, so they will not happen
written by Blissex, September 15, 2013 7:42
«Clearly fraudulent mortgages were a major factor in propping up the housing bubble. No one went to jail for this crime.» «Go after these guys and confidence will be lost in the banks and the economy will tank.»

Essentially all securities arising from fraud ended up in derivatives, whether mortgage backed or not.

Essentially all derivative contracts have a clause that if the underlying securities are tainted with fraud the buyer of the derivative can return them to the seller for a refund at 100% of face value, even if those derivatives trade at 20% or 5%.

Therefore if the USA convicts Wall Street of trading fraudulent securities, all the buyers of derivatives on those securities would be able to return them for a full refund, triggering the effective bankruptcy of the whole USA financial system.

Derivatives have effectively made securities fraud unpunishable if done on a medium-large scale.
need clarification on the cost of unwinding derivatives due to fraud.
written by Justafed, September 15, 2013 12:07
Blissex points out that there are likely clauses buried in derivatives contracts that could have a chilling effect on prosecutions for fraudulent activity in the financial markets. And that unwinding those derivatives would be difficult and costly. But I am confused by the notion of "refund" here, at least for many kinds of derivatives. In an interest rate swap, for example, the two parties swap income streams deriving from some underlying asset. If one of the assets is an MBS with fraudulent loans in it, it is easy to see that one (or both) parties may wish to escape from the agreement, but I'm not seeing any strike price to refund. Now, there could be a strike price if I essentially bought an option on that swap (or on the price of an MBS, or anything else), and a fraud clause could give me a way to get that back, but what I would get back is the strike price, not the face value of the underlying security. In addition, a lot of the big financial institutions had very large positions in many different kinds of derviatives contracts and mostly were making these contracts with each other, so it is not clear to me that when you "netted out" those tainted by fraud that the number of or losses incurred by catastrophic losers would exceed what we actually experienced. You have to remember that Citi and BofA were flat out insolvent when bailed out, and the costs of "saving" them were and are non-trivial.

I could be convinced the situation would have been more dire with fraud convictions, but I need more to go on than the information that many derivatives contracts have provisions allowing you to get a refund.
Meeting the criminal fraud test
written by Jay Weiser, September 15, 2013 12:13
In order to prove fraud by a senior executive, prosecutors would have to prove beyond a reasonable doubt that the senior executive:

-Made a false representation of a material fact
-Knew the representation was false
-Intended to deceive or induce the contract
-The victim justifiably relied on the representation and
suffered injury

Given the attenuated chain of information from originator or securitizer up to CEO, this would be very difficult to prove, even if the CEO's ethical compass was lacking. This level of culpability is difficult to prove even at the originator/securitizer level.

Civil fraud, which requires proof only by a preponderance of the evidence, is much easier to prove, and that is why we've been seeing large civil fraud settlements.

No penalty for bad business judgment?
written by Cinc, September 17, 2013 4:52
Of course, fraud should be prosecuted. But why are any of the top-level managers of the investment houses and bankings that needed taxpayer bailout still employed? Surely the punishment for bad business judgment is (or should be) dismissal? That would be a much better and easier approach: if you want a bailout, then the incompetents in charge must go.
The MBS "goes away"
written by grumpy, September 18, 2013 10:54
The primary effect of fraudulent MBS securitization (because of non-compliant mortgages in the security) is to allow the buyer of the mbs to put it back to the originator at par. This is where the whole "derivatives blows up" begins. All of a sudden all the downstream financial engineered deals blow up ("must be unwound"). Given the prevalence of non-conforming ("crap") mortgages in the non-GSE MBS, this would be a huge hit to the financial system.

Rather than have the feds come in and prosecute (at a high, but probably reachable level of proof) the powers that be (must have) decided to let it play out over a longer period of time in the civil courts. The civil actions have many different outcomes over a long time frame. This diffuses the pain and the news value -- rather than a few big trials which might hit the front page there are many smaller, one-paragraph stories in the business section. Additionally, since each of the banks can sue other banks on selected securitizations there are opportunities to coerce settlement and reduce the number and effect of cases brought. All these incentives reduce the P.R. impact and the likelihood of catastrophic financial system failure.

The prosecution of the big-wigs doesn't need to happen on criminal fraud. The easier win on any federal prosecution would be under Sarbanes-Oxley where it should be fairly easy to prove that the executives at the top were certifying financial reporting that was not done with proper diligence.

There is no way if there is no will.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.