This might seem like an exaggeration. It’s not. Let us now review 1) the growth of financial criminality and its declining punishment; 2) the nature, severity, and consequences of illegal conduct during the bubble and financial crisis; and 3) actual and potential responses to this conduct.
The Rise of Post-Deregulation Financial Criminality
THE FIRST MAJOR outbreak of deregulation-era financial crime came promptly after the Reagan administration’s deregulation of the savings and loan industry. The S&L scandal established a pattern that has intensified ever since. Since the early 1980s, financial sector criminality has sharply increased, particularly in investment banking and asset management, while prosecution and punishment have declined nearly to zero. People employed by major, politically powerful banks are almost never prosecuted, and rarely if ever imprisoned, and there is a striking disparity in treatment of identical crimes as a function of the criminals’ institutional affiliations, or lack thereof. The overwhelming majority of financial sector offences that are criminally prosecuted are committed by asset and hedge fund managers, by individuals who provide confidential information for insider trading, or by individual investors. Thus Bernard Madoff, Raj Rajaratnam, and Martha Stewart are prosecuted; executives of Goldman Sachs, JPMorgan Chase, Citigroup, and even Lehman Brothers have not seen similar charges.
The S&L, leveraged buyout, and insider trading scandals of the 1980s were the only ones for which significant numbers of politically powerful bankers were prosecuted. There were several thousand criminal prosecutions, resulting in prison sentences for prominent and wealthy executives such as Charles Keating and Michael Milken. Even then, few prosecutions were directed at the core of the financial sector, in part because it had not yet become highly criminalized. The worst offences, and most prosecutions, occurred in the industry’s periphery. Keating ran a West Coast S&L that went bankrupt; Milken worked for Drexel, which had been a small, second-tier investment bank until his arrival. Even then, however, there were disturbing signs. For example, the very well-established accounting firm Ernst & Young had failed to warn about massive accounting irregularities by its S&L clients and agreed to pay fines totalling over $300 million, and some prestigious investment banks had worked for greenmailers and fraudulent S&Ls.
But it was in the late 1990s that, for the first time since the 1920s, the largest, oldest, and most important firms in finance went off the rails. The expansion and consolidation of the financial sector in the 1990s, the Internet bubble, the rising power of money in national politics, and further deregulation together created an unprecedented opportunity for bankers to make money improperly, and some seized this new opportunity with astonishing enthusiasm.
On 7 November 2011, the New York Times published an article based on its own review of major banks’ settlements of SEC lawsuits since 1996. The Times’ analysis found fifty-one cases in which major banks had settled cases involving securities fraud, after having previously been caught violating the same law, and then promising the SEC not to do so again.1 The Times’ list, furthermore, covered only SEC securities fraud cases; it did not include any criminal cases, private lawsuits by victims, cases filed by state government prosecutors and attorneys general, or any cases of bribery, money laundering, tax evasion, or illegal asset concealment, all areas in which the banks have numerous violations. Here is a tour of some major cases.
Enron
ENRON, WHICH SUFFERED the largest bankruptcy in American history, was the stock market’s darling in the late 1990s. Enron was also politically well connected, particularly to Republicans. Based in Texas, it was a strong supporter of Governor George W. Bush. As noted earlier, its board of directors (and its audit committee) also included Wendy Gramm, a former chairperson of the Commodity Futures Trading Commission and the wife of Phil Gramm, then the chairman of the US Senate Banking Committee.
Previously a staid energy pipeline company, in the 1990s Enron expanded into energy trading, bandwidth trading, and derivatives trading in order to cash in on the deregulation of electricity production, telecommunications, and financial services. Enron’s operations were highly fraudulent, both financially and operationally, but the company continued to grow, with twenty-two thousand employees at its peak. Enron faked its bandwidth and energy trading and artificially withheld electricity supplies to raise prices, behaviour that played a role in the severe electricity shortages that plagued California in 2000–2001. Enron also committed massive financial frauds to create artificial profits and to hide liabilities and losses.
But what was particularly notable about the Enron affair was that Enron’s frauds depended deeply on long-term cooperation from its accounting firm, one of the “Big Five”, and also several of America’s largest banks.
In its financial frauds, Enron’s principal technique was to create off-balance-sheet entities known as SPEs, or special purpose entities, which it used to create fictitious transactions that made streams of borrowed money look like revenues. In the years just before it collapsed in 2001, Enron’s earnings may have been overstated by as much as a factor of ten.2 Some of the world’s best-known banks knew exactly what Enron was doing and lined up for the privilege of helping it perpetrate this fraud. They all did basically the same thing—namely, create sham transactions to inflate revenues or assets.
Starting in 1997, Chase Bank, now part of JPMorgan Chase, helped Enron create false gas sale revenues. The transactions involved two fictitious offshore entities, both with the same nominal director and shareholders. One of them, Mahonia, borrowed from Chase to “purchase” gas from Enron, for which it paid cash. The second, Stoneville, “sold” the same amount of gas at the same price to Enron, and was paid with long-term interest-bearing Enron notes. Behind the smokescreen, Chase was making a loan to Enron and conspiring to make the loan proceeds look like revenues. Over several years, the scam created $2.2 billion in fake gas revenues and associated profits.
Citigroup started doing the same thing in 1999, when Enron was trying to cover up a huge shortfall in projected revenues and cash flow. Citigroup agreed to help, and presto—Enron had nearly a half billion dollars of new positive operating cash flow. Enron used this trick again and again, and the total fictitious trading cash flows appear to have been on the same scale as the Chase Mahonia scam. Again, the record leaves little doubt that Citigroup knew what it was doing.3
Finally, there was Merrill Lynch. Enron asked Merrill to buy two Nigerian power barges (yes, Nigerian power barges) at an inflated price—subject to a handshake deal that Enron would buy them back. Merrill may have had concerns about the transaction, but consciences might also have been eased by a 22 percent fee. Enron later tried to weasel out of the deal, which prompted some screaming matches. Merrill eventually got its money back, although Enron had to construct another fake transaction to produce the cash. Almost simultaneously, another Merrill team helped Enron with the purely fictitious sale and repurchase of a power plant. Nothing substantive had occurred, but Merrill got a very real $17 million fee for helping Enron create fake revenues and profits.4
Enron’s accounting firm, Arthur Andersen, was criminally prosecuted and forced out of business. Several Enron executives went to prison; the former president, Jeffrey Skilling, is still serving his twenty-four-year term, while Kenneth Lay, the CEO, died shortly before commencing his sentence. Class-action lawsuits were also filed against Enron, Arthur Andersen, and the banks. A partial list of the financial settlements with the banks from both the private and public actions are shown in Table 2 below.
5
But not a single one of the banks, or the individual bankers, that helped Enron fake its profits was criminally prosecuted. Aiding and abetting fraud was now permissible.5
The Internet Bubble: Eliot Spitzer as a Lonely Man
AT THE SAME several banks were helping Enron commit accounting fraud, the Internet frenzy was driving the US stock market, particularly the Nasdaq. Nearly the entire investment banking industry, its oldest and most p
restigious firms very much included, fraudulently magnified the Internet bubble to gain business. The Internet bubble marked the first appearance of the new culture of dishonesty throughout mainstream finance.
Consider a priceless exchange between a Merrill Lynch broker and Henry Blodget, a youthful Merrill technology analyst, in 1998. In an internal e-mail regarding one of his favourite stock recommendations, Blodget described his private view of the company as “pos”. The broker asked Blodget why his view was “positive”, since she thought the company’s numbers looked pretty weak. Blodget helpfully explained that “pos” didn’t mean positive. It meant piece of shit.6
Morgan Stanley’s Mary Meeker, another star technology analyst, was reportedly paid oceans of money for helping Morgan Stanley secure Amazon’s investment banking business. (Both she and the bank were later sued on the basis of those conflicts.) Meeker was also deeply involved in pitching the AOL/Time Warner merger to the Time Warner board. Morgan Stanley stood to reap a large fee if the deal closed. And close it did, becoming one of the worst corporate mergers in history.7
Even Blodget and Meeker weren’t as conflicted as Jack Grubman, the telecommunications analyst at Salomon Brothers (later Salomon Smith Barney). For years, he pushed Global Crossing and WorldCom, both of which turned out to be fraudulent disasters. Grubman was especially close to Bernie Ebbers, then CEO of WorldCom, coaching him on his presentations to other analysts. Ebbers was later convicted of accounting fraud, and is still in prison. An angry broker complained that Grubman maintained his “buy” rating on Global Crossing “from $60 all the way down to $1.”
As the bubble peaked, Grubman decided to downgrade a half dozen of the companies he followed but then reversed himself at the request of the investment bankers. After long denigrating AT&T, he switched to a “strong buy” in 1999—allegedly based on the company’s new cable strategy, but really, it appears, because Salomon’s new parent, Citigroup, had just won AT&T’s investment banking business.8
Such behaviour was common during the Internet bubble. Particularly for dot-com companies, the divergence between investment banks’ public statements and the private views of analysts was frequently vast. Investment banks supposedly maintained “Chinese walls” between their research and investment banking departments, but it was a charade. Favourable analysts’ reports were a key marketing tool in selling investment banking services, and analysts’ pay was explicitly based on the investment banking revenues they generated. So they danced to their masters’ tune, much as the rating agencies did during the mortgage bubble.
The Internet bubble was very profitable—the volume of private placements, IPOs, mergers, and acquisitions was far greater than anything seen before on Wall Street. A very high fraction of it was fraudulent, and it caused an enormous wave of losses, bankruptcies, failed acquisitions, and write-downs in 2000 through 2002. Companies such as Excite, Infospace, pets.com, WorldCom, Covad, Global Crossing, boo.com, startups.com, Webvan, e.digital, and many others received high investment ratings from bankers shortly before collapsing. Frequently the banks also paid fees, which might be considered barely disguised bribes, to individual executives in order to obtain their company’s business. But because the major investment banks all wanted IPO business, and because they syndicated portions of most IPOs to each other, none of them was incented to be honest in their analyst research.
The Clinton administration did nothing—not the SEC, not the Justice Department, nobody. The Bush administration was no better. The SEC became interested only after the New York State attorney general, Eliot Spitzer, filed a series of highly publicized lawsuits against the leading banks, which public pressure then compelled the SEC to support. In late 2002 there was a mass settlement with ten banks for $1.4 billion for “fraudulent research reports”, “supervisory deficiencies”, and subjecting analysts to “inappropriate pressures” from investment bankers. The largest single penalty, $400 million, was paid by Citigroup, while Merrill and Credit Suisse First Boston paid $200 million each, and Goldman Sachs paid $110 million. A few mid-level analysts—very few—were prosecuted. Blodget and Grubman were barred from the securities industry for life and paid fines of $4 million and $15 million, respectively. Meeker was not fined and went on to lead Morgan Stanley’s technology research unit.9
Here are some excerpts from my interview with Eliot Spitzer.
SPITZER: Indeed, the defence that was proffered by many of the investment banks was not “You’re wrong”; it was “Everybody’s doing it, and everybody knows it’s going on, and therefore nobody should rely on these analysts anyway.”
CF: Did they really say that to you?
SPITZER: Oh yes . . . this was said to us. This was . . . And the other piece of it was, “Yes, you’re right, but we’re not as bad as our competitors, because everybody does it, and you should go after them first.” And so there really wasn’t an effort to deny that this intersection of analysts and investment bankers had generated a toxic combination. It was really, “Why are you going after us?” Again, it was the jurisdictional issue, and there were what they called Spitzer amendments floated up on Capitol Hill. Morgan Stanley went down to the House Financial Services Committee, this is when it was under Republican control, and they worked very hard with the SEC support to get an amendment through that would’ve limited and eliminated our jurisdiction and our ability to ask the questions. We beat that back with a fair bit of publicity.
Then I asked him about criminal prosecution:
CF: Did you ever think of prosecuting any of these people criminally?
SPITZER: We thought long and hard about it.
CF: Why didn’t you?
SPITZER: I’ll tell you why. . . . The only realistic targets in that criminal case would’ve been the analysts who are essentially mid-level individuals at the investment houses. And so I said to myself, “Yes, we could probably make a criminal case against a mid-level analyst, but the analyst is doing what he has been asked and told to do by the creation of an entire structure that preordained this outcome.” We probably won’t be able to make a criminal case against those higher up in the spectrum.
CF: Even though you think they were guilty?
SPITZER: Even though they understood that the system was generating analytical work that was flawed, it was going to be impossible to prove that the CEO knowingly instructed somebody to say something that was untrue, just because the e-mail chatter was down [t]here. As you move up the hierarchy, the CEO would say, “Well, of course we have analysts, of course they’re telling the truth. Now, do we compensate them based upon how much investment banking business they bring in? Sure, but I never said to them, ‘Lie.’ ” But the lies flowed almost necessarily from the system that was created.
CF: Was it, and is it, your personal opinion that the senior people were in fact guilty?
SPITZER: My view is that anybody within the investment bank was aware of the fact that the analytical work was tainted by the desire to bring in investment banking business, and that . . . the entire business model depended upon it. . . .
So if you use the word “guilty” in a generic sense, yes, they were guilty of knowing that something was wrong. Guilty in a sense that they were provably guilty of a criminal case is a very different matter.
CF: Not provably. My question was not about . . . I understand your point about proof. But there’s a difference between proof and what your opinion is about their real culpability.
SPITZER: Were they guilty of knowing that the analytical work was being tainted and damaged by the desire to get investment banking business? Yes.
Part of Spitzer’s reluctance to prosecute may have come from the realities of his situation. He had fewer than twenty attorneys dealing with the investment banks, who outspent him at least ten to one; the Bush administration and the SEC were, to put it mildly, unenthusiastic; and although the offences and their damage were serious by the standards of the time, they were utterly trivial compared to those committed since. The question
of proof is, of course, an important one, and we will return to it in considering the mortgage bubble and the financial crisis.
JPMorgan Chase Captures a County
MUNICIPAL BOND ISSUANCE is one of the murkier backwaters of finance, as subprime mortgages used to be. It is also notoriously corrupt, and left a wake of extraordinary destruction in Alabama’s Jefferson County, which includes the state’s largest city, Birmingham.10
In the late 1990s, Jefferson County settled a long-running dispute with the US Environmental Protection Agency by undertaking a major sewer project, financed with $2.9 billion in long-term fixed-rate bonds with an interest rate of 5.25 percent. As rates fell in the early 2000s, bankers descended on the county offering to restructure the debt and save millions in interest payments. JPMorgan Chase led a group of thirteen banks in structuring the deal and allocating its components. Instead of simply refinancing with straightforward fixed-rate bonds at a lower rate, the banks created an artificially complex deal to increase their fees. They issued $3 billion in various floating-rate instruments, while supposedly offsetting the risk of rate increases with interest-rate swaps. JPMorgan Chase used instruments called auction-rate securities, which caused billions in losses for many cities in 2008, along with other variable-rate bonds.
According to Bloomberg and the SEC, the banks earned $55 million in fees for selling the auction-rate securities. The interest-rate swap contracts generated another $120 million in fees, which, according to an analyst later engaged by the county, was about six times the market norm. JPMorgan Chase was able to make this deal because it also made under-the-table payments of $8.2 million to local officials and brokerage firms. The largest payments, however, were made to other banks, including $3 million to Goldman Sachs and $1.4 million to a New York municipal bond specialist for agreeing to withdraw from the competition. All of the illicit payments were charged as fees deducted from the funds raised for the county. Naturally, there was no disclosure of the payments in the bond prospectuses.
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