“I’m really concerned that ‘too big to fail’ has become ‘too big for trial.’” Last Thursday, newly elected
Democratic Senator Elizabeth Warren grilled bank regulators during her first hearing as a member of the Senate Banking Committee.
Sen. Warren pressed the regulators, “[w]hat I’d like to know is tell me a little bit about the last few times you’ve taken the biggest financial institutions on Wall Street all the way to a trial.” The Senator has perhaps become the most vocal and prominent voice of frustration over an apparent lack of justice in connection with the recent financial crisis that nearly crippled the country.
Since the March 2008 collapse of the investment bank Bear Stearns signaled the beginning of the economic crisis from which we are still struggling to recover, not one single criminal charge has been brought against any of the major American banks or credit rating agencies or any of their top executives. Many of the same parties widely considered the major cause of the crisis also benefited from it through outrageous bonuses, salaries and investment profits.
Any discussion of the financial crisis that started in 2008, and the collapse of the home mortgage market that began it, is complicated and confusing and most observers have their own favorite culprit. Republicans have agreed that Congressman Barney Frank and other Democrats in Washington are at fault for supporting less stringent mortgage lending requirements with the goal to provide more Americans the opportunity to own their homes. Blame has been directed toward the former Chairman of the Federal Reserve, Alan Greenspan, who led the manipulation of interest rates for years that allowed the historic inflation of home prices to unsupportable levels.
Yet, regardless of the blame theory to which you subscribe, it is an inescapable fact that the particular financial crisis that has consumed world economies for nearly five years would not have occurred without the use of unregulated, bizarre financial instruments like the collateralized debt obligation (CDO) and credit default swap.
The CDOs that were at the heart of the crisis were financial investment products made up of many home mortgages on properties in every corner of the country. Over the years of their existence, the mortgage CDOs included increasing percentages of subprime mortgages at great risk of default. A continuing supply of new mortgages was needed to supply the growing market for CDOs. That supply was enabled through lower lending standards and strange mortgages that enticed borrowers by misleading them about the real interest rates and other obligations they would assume.
Other tricks were used to convince the needed investors to buy the CDOs. The illusion of investment risk diversification was created through the use of mortgages from various regions of the country. But, of course, what really convinced the buyers were the irrationally high credit ratings awarded by the investment rating agencies S&P, Moody’s and Fitch. The new, strange investments were granted the highest AAA rating and the identification of low risk that the rating signifies.
Recently, a bright light has been focused on the motivations that guided many of those apparent stellar ratings. Last month, the U.S. Justice Department filed a civil lawsuit against S&P. The suit alleges that the ratings agency committed massive fraud by granting high credit ratings to many known high-risk CDOs solely for the purpose of appeasing their clients, the banks that created the CDOs and paid S&P high fees for providing the ratings.
In an August 2004 e-mail, an S&P executive revealed that “[w]e are meeting with your group this week to discuss adjusting criteria for rating CDOs (a type of investment) of real estate assets this week because of the ongoing threat of losing deals.”
In June 2005, an S&P employee, a quantitative analyst (or ‘quant’), asserted that “[i]f we are just going to make it up in order to rate deals, then quants are of precious little value.”
Correspondence between an S&P analyst and an investment banker from July 2007 included an apparent admission from the analyst. “The fact is, there was a lot of internal pressure in S&P to downgrade lots of deals earlier on before this thing started blowing up. But the leadership was concerned of pissing off too many clients and jumping the gun ahead of Fitch and Moody’s.” The investment banker’s reply was equally revealing. “This might shake out a completely different way of doing biz in the industry. I mean come on, we pay you to rate our deals, and the better the rating the more money we make?!?! Whats up with that? How are you possibly supposed to be impartial????”
Perhaps equally appalling as the actions of the ratings agencies were those of the market participants that created, sold or otherwise promoted the CDOs, and simultaneously bought credit default swaps. This type of swap investment is essentially an insurance policy that will pay its owner upon the default of mortgages within the insured CDO.
The problem was that the buyers of the ‘insurance’ no longer owned the CDOs on which the insurance was based. The arrangement has been compared to a homebuilder that constructs a house with intentionally cheap and shoddy construction in the middle of a high-activity earthquake zone, sells the house to an unsuspecting buyer, and immediately buys earthquake insurance against the house that the builder no longer owns. The unscrupulous builder hopes that the house, which is now owned by someone else, will eventually collapse and the insurance policy will pay a handsome sum to that builder even though he has suffered no loss.
In a 2010 hearing before the Senate Banking Committee, Senator Carl Levin’s questioning to Loyd Blankfein, the CEO of Goldman Sachs, centered on the banks activities that mirrored the acts of the hypothetical homebuilder. As Goldman Sachs employees sold CDO investments to the bank’s client, e-mails revealed that they privately called those investments “crap,” “crappy” and “shitty.” Then the bank bet against those CDOs and profited from their demise. As Senator Levin emphasized, Goldman Sachs never disclosed to its clients the belief that the investments it was selling was expected to fail, or, more importantly, that Goldman Sachs was intending to put it own money behind bets about how likely that failure was.
In the Justice Department’s civil lawsuit against S&P, they are seeking $5 billion in fines and penalties. While the civil lawsuit is certainly a good start, it may be much too little. “In early 2010, the Securities and Exchange Commission (SEC) settled a different lawsuit against Goldman Sachs that was related to the financial crisis. Goldman Sachs was required to pay a hefty-sounding $550 million fine. Yet, it’s been noted that the bank earns about that amount every three weeks.
Additionally, and perhaps more importantly, critics are disappointed and disillusioned by the Justice Department’s failure to bring criminal charges, rather than only civil charges, against those responsible. Criminal charges could require time behind bars, and not simply the return of small portions of the fortunes amassed.
Former Democratic Senator Ted Kaufman, who served on a Senate panel that investigated the financial crisis, has consistently and loudly argued that the actions by the banks and ratings agencies, and their employees, amounted to criminal fraud. “If you’re selling something that you’re saying has a certain level of safety, and you know it doesn't have that level of safety, that’s fraud.”
As Sen. Kaufman observed, large civil fines mainly end up hurting a company’s shareholders. “The executives, the folks that did it, aren’t going to pay anything,” according to Kaufman. Additionally, many of the government’s civil cases end in settlements that don’t require any admission, or finding, of fault. That was the case with the Goldman Sachs $550 million settlement.
The Justice Department’s suit against the S&P alleges extensive fraud. The possible bases of criminal claims against Wall Street are various and include interest-rate rigging, money laundering and securities fraud. Given the variety of potential claims, the absence of cases might be surprising.
According to a December 6, 2011 article in the Wall Street Journal, “[a] former top U.S. official in charge of investigating the financial crisis said the government has concluded that many inquiries of wrongdoing by financial executives can’t succeed as criminal prosecutions” and that it’s “better left to regulators.” To succeed with a civil lawsuit, the government must only prove its case ‘by a preponderance of the evidence,’ while a criminal conviction requires guilt ‘beyond a reasonable doubt.’
Possibly the only notable criminal charges that have come out of the crisis resulted in acquittals. In November 2009, the Justice Department was unsuccessful in its criminal case against two former Bear Stearns executives for securities, mail and wire fraud.
A report about the lack of Wall Street criminal prosecutions, called ‘The Untouchables,’ recently aired on the PBS program
Frontline. It included an interview of Lanny Breuer, the assistant attorney general for the Department of Justice’s Criminal Division, in which he acknowledged "losing sleep at night" worrying about whether Wall Street criminal prosecutions would harm the country’s economic recovery. Shortly after the airing of that interview, Mr. Breuer resigned from his position with the Department of Justice. It is not known whether adverse reaction to the interview played a part in his departure.
If Mr. Breuer was frozen into inaction by fear that Wall Street criminal prosecutions might cause instability in the financial system, then we may have reached the scenario of “too big to fail.” It’s a situation described in a recent New York Times editorial as “a dark day for the rule of law.”
Of course, it has also been observed that the ‘revolving door’ between Wall Street executive jobs and positions as government regulators might ‘soften’ the tools used in regulatory enforcement. A regulator is unlikely to be enthusiastic about a criminal investigation of a former, and possibly future, colleague.
In August 2012, the U.S. Justice Department closed a criminal investigation of Goldman Sachs and Mr. Blankfein. Senator Levin asserted that “whether the decision by the Department of Justice is the product of weak laws or weak enforcement, Goldman Sachs’ actions were deceptive and immoral.”
In addition to Goldman Sachs, the Justice Department has already passed on cases against Countrywide Financial and the American International Group (AIG), and the executives that led those firms. Another investigation into Lehman Brothers, and an accusation that it misled investors by using accounting tricks to hide the amount of leverage on its books, also appears to be going nowhere.
The decision not to pursue a case against Goldman Sachs may have ended the possibility that any criminal blame or punishment might be applied in connection with the events and the schemes that led to our country’s greatest financial crisis since the Great Depression of the 1930s. Some statutes of limitations have passed, like the five year limit for bringing a securities law fraud case. Most of the actions that might be criminal occurred prior to the market collapse in 2008.
Unlike this current crisis, in the wake of the less-costly savings-and-loan scandal of the 1980s and early 1990s, over a thousand criminal convictions were obtained and many executives, like Charles Keating of Lincoln Savings & Loan, went to jail. However, the investigations of those crimes reportedly included the work of 1,000 FBI agents. After the terrorist attacks of 9/11, the focus of the FBI changed and only 200 agents remained to pursue the financial crimes of the recent crisis.
Former Senator Kaufman has done a pretty good job of summarizing the importance of criminal penalties for the firms and executives involved. “How come you can steal five dollars and have a penalty and steal $500 million and get off absolutely scot-free? ... We find that criminal penalties are extremely effective in dealing with white-collar crime, even more than non-white-collar crime. … So it was really important to me that we send a message that this kind of behavior would not be tolerated.”
Sen. Kaufman emphasized the importance of sending the message that the law applies to everyone. Last Thursday, Sen. Warren continued that thought and pointed out that “there are district attorneys and U.S. attorneys who are out there everyday squeezing ordinary citizens on sometimes very thin grounds and taking them to trial to ‘make an example,’ as they put it.”
Yet, no ‘examples’ were apparently deemed necessary in connection with this country’s largest financial crimes which brought the world’s economies to their knees. With more loud advocates like Senator Warren, we might yet prevent a Wall Street ‘too big for trial.’