Wells Fargo, as the successor/owner of Wachovia, cooperated with the investigation and agreed to pay a $160 million fine and implement a robust money-laundering detection system. Similar settlements for similar violations were reached with Bank of America and twice with subsidiaries of American Express. Amex paid a $55 million fine when its Edge Act subsidiary, AEBI, was caught facilitating money laundering for Colombian drug lords in cooperation with the Black Market Peso Exchange from 1999 through 2004.26
And then there is Bernie Madoff—or rather, the banks’ treatment of him.
Jumping on Board with Bernie
BERNARD L . MADOFF, philanthropist, reliable friend, former chairman of the Nasdaq stock exchange, and creator of one of the first electronic trading platforms, also ran the biggest pure Ponzi scheme in history, operating it for thirty years and causing cash losses of $19.5 billion.27
Shortly after the scheme collapsed and Madoff confessed in late 2008, evidence began to surface that for years, major commercial and investment banks had strongly suspected that Madoff was a fraud. None of them reported their suspicions to the authorities, and several banks and bankers decided to make money from him, without, of course, risking any of their own funds. Theories about his fraud varied. Some thought he was “front-running”, examining the orders passing through his electronic trading business and then using this information to place his own trades in front of them. Some thought he might have access to insider information. But quite a few thought that he was running a Ponzi scheme.
Madoff claimed to be tracking the S&P 500 stock index, while using options to slightly increase returns while reducing volatility in the value of his portfolio.
But there were just a few little problems. For instance:
• When others tried to replicate Madoff’s strategy or apply it retrospectively, they found that his results could only be achieved by always buying at or near the market’s low and always selling at or near the market’s high—which is impossible. Madoff claimed to have had negative monthly returns only five times in fifteen years of operation. In one period in 2002 in which the S&P 500 lost 30 percent, Madoff claimed that his fund was up 6 percent. Such performance was both inconsistent with his supposed strategy and totally unprecedented in investment fund management.
• Although Madoff’s stated strategy entailed massive trading volumes in both shares and options, no one knew who his trading counterparties were, nor was there ever any visible sign of his moves in and out of the market. Actually pursuing his strategy would often have required trading more options than existed in the entire market.
• Madoff simultaneously served as the broker executing the trades, the investment adviser, and the custodian of the assets. Such an arrangement obviously lacks checks and balances and is conducive to fraud. It is unheard of for an operation on the scale of Madoff’s, and was repeatedly noted as a danger sign. Madoff also employed his brother, niece, nephew, and both of his sons in his business.
• His auditing firm was a little known three-person firm in a suburban roadside “strip” shopping mall. One of the three was a secretary, and one was a semiretired CPA who lived in Florida. The firm was not professionally qualified to perform audits and did not hold itself out as an auditor.
• Account statements were typed, not electronically printed, and the firm used only paper trading tickets, both of which were inconsistent with the required volume of trading. Investors were never given real-time or remote electronic access to their account information; they only received paper statements in the mail.
• Despite his enormous purported success, Madoff did not charge any hedge fund management fees. He claimed that he made his money simply by having his own trading platform process all of his trades, a highly implausible claim. The real reason that he did not charge the typical 20 percent of profits was that he needed to attract new money to keep the scheme going as long as possible.
These problems and many others—we’ll get to those in a minute—were repeatedly cited as warning signs by banks and hedge funds that either dealt with Madoff or were considering doing so. Goldman Sachs executives paid a visit to Madoff to see if they should recommend him to clients. A partner later recalled, “Madoff refused to let them do any due diligence on the funds and when they asked about the firm’s investment strategy they couldn’t understand it. Goldman not only blacklisted Madoff in the asset management division but banned its brokerage from trading with the firm too.”28 Risk managers at Merrill Lynch, Citigroup, UBS, JPMorgan Chase’s Private Banking, and other firms had done the same. The Merrill parent company, for example, had expressly forbidden dealings with Madoff from the 1990s.29 They all suspected fraud of some kind.
As a result, most of the major banks declined to invest their own money with Madoff. However, they did sometimes allow their clients to invest. A number of banks, including Merrill Lynch, Citigroup, ABN Amro, and Nomura, also created various tracking funds to replicate Madoff’s returns,7 even though all suspected fraud.
But UBS and JPMorgan Chase were even more deeply involved. UBS created a new family of “feeder funds” to send assets to Madoff. (Madoff generally did not accept direct investments, preferring to receive money via these “feeder funds”.) Most feeder funds acted as little more than drop boxes and made few, if any, investments except into Madoff’s fund. There is strong evidence that several of them suspected Madoff was a fraud. But Madoff paid them about 4 percent per year for doing virtually nothing, so they were happy to look the other way.
UBS created or worked with several Madoff feeder funds, even though UBS headquarters forbade investing any bank or client money in Madoff accounts. The feeder funds were required by law to conduct due diligence, and one of them hired a due diligence specialist named Chris Cutler. After four days, he wrote to the feeder fund: “If this were a new investment product, not only would it simply fail to meet due diligence standards: you would likely shove it out the door. EITHER extremely sloppy errors OR serious omissions in tickets.” Cutler found, for example, that Madoff’s claimed strategy implied trading a number of options that was far higher than the total number actually traded on the Chicago Board Options Exchange.30 The fund proceeded with its Madoff investments anyway.31
UBS explicitly instructed its employees to avoid Madoff. A memo to one of the feeder funds in 2005 contained a section entitled “Not To Do”. In this section was the following, in large boldface type: “ever enter into a direct contact with Bernard Madoff!!!” One of the UBS executives involved in creating the new funds received a headquarters inquiry on what he was doing. He replied, “Business is business. We cannot permit ourselves to lose 300 million,” referring to anticipated fund management revenues.32 UBS proceeded to issue fund prospectuses in which it represented that it would act as custodian, manager, and administrator of the feeder funds, when in fact they had already agreed with Madoff to play no such role. Like all Madoff sponsors, UBS received no information except paper summaries of monthly results.
JPMorgan Chase was, if anything, even more dishonest. Like Merrill Lynch and Citigroup, they set up Madoff tracking funds despite explicit warnings from an executive in JPMorgan Chase’s Private Bank unit that he “never had been able to reverse engineer how [Madoff ] made money.”33 But JPMorgan Chase had even more evidence, because they served as Madoff’s primary banker for more than twenty years.8 Anyone with access to those accounts would know that something was seriously wrong. For example:
• An investment company with thousands of individual customers should have credited incoming funds to segregated customer accounts or directed them into multiple other subaccounts. Instead whatever came in was more or less tossed into a single pot.
• Know Your Customer (KYC) rules for business accounts were greatly strengthened after 9/11, and JPMorgan Chase insisted it took its KYC obligations very seriously. A KYC department was attached to every line of business. But the identified KYC “sponsor” on the Madoff account, when interviewed by the Madoff ban
kruptcy trustee, was unaware that he had been so designated and did not know what the job entailed.
• JPMorgan Chase received copies of the mandatory financial filings that Madoff made with the SEC. They were usually wrong, often wildly so. One statement listed $5 million in bank cash accounts, when the actual amount at JPMorgan Chase was $295 million. Another listed no outstanding bank loans, when there was a $95 million loan outstanding. For years, the statements showed no trading commission revenue, even though they were supposed to be the primary source of Madoff’s income (he did not charge management or incentive fees). Then one year, the statements suddenly showed more than $100 million in commissions, although none were in the product categories that were supposed to dominate his strategy. Madoff’s prospectuses represented that idle cash was always invested in US Treasury bills, when JPMorgan Chase knew it was almost all in overnight deposits.
• Money-laundering regulations are quite strict and impose obligations on banks to report suspicious activity. JPMorgan Chase has an automated alert system that is supposed to trigger a review and report whenever a “red flag” event occurs. How about a customer who received 318 transfers of exactly $986,310 each in a single year, often several per day? No problem, no alert.
• Several of Madoff’s biggest customers were also JPMorgan Chase Private Banking customers, so the bank could see both sides of the transactions. And indeed they often saw hundreds of millions of dollars washing back and forth between client accounts and Madoff, sometimes billed as loans but often with no explanation at all. In the entire history of the Madoff accounts, the automated money-laundering system generated only a single alert, which was not followed up.
With all that, they must have suspected something—and indeed they did. The lawsuit filed by the Madoff bankruptcy trustee against JPMorgan Chase makes for astonishing reading. More than a dozen senior JPMorgan Chase bankers had discussed in e-mails and memoranda, as well as in person with each other, a long list of suspicions. On 15 June 2007, one employee said to another: “I am sitting at lunch with [redacted] who just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a Ponzi scheme.” At the same time—June 2007—three members of JPMorgan Chase’s executive committee openly discussed this possibility at a meeting. They were John J. Hogan, chief risk officer for investment banking; Matthew E. Zames, a senior trading executive; and Carlos M. Hernandez, head of equities for the investment banking unit. After Madoff’s arrest, Hogan’s deputy, Brian Sankey, suggested that it would be preferable if the meeting agenda “never sees the light of day again.”34 But Madoff produced a half billion dollars in fee revenue for JPMorgan over the years.
The SEC has been deservedly criticized for not following up on years of complaints about Madoff, many of which came from a Boston investigator, Harry Markopolos, whom they treated as a crank. The SEC also bungled its own investigations of Madoff. But suppose a senior executive at Goldman Sachs, UBS, or JPMorgan Chase had called the SEC director of enforcement and said, “You really need to take a close look at Bernard Madoff. He must be working a scam. No proof, but here are five very suspicious facts, and here’s what you should look for.” If it came from them, the SEC would have had to pay attention, even in the pitiful, toothless state to which it had been reduced in the Clinton and Bush administrations. But not a single bank that had suspicions about Madoff made such a call. Instead, they assumed he was likely a crook, but either just left him alone or were happy to make money from him.
The Financial Crisis as the logical Culmination of Financial Criminalization
TAKEN TOGETHER, THE foregoing suggests a major cultural change in global banking, and in its treatment by regulators and law enforcement authorities. Since the 1980s finance has become more arrogant, more unethical, and increasingly fraudulent. Tolerance of overtly criminal behaviour has now become broadly, structurally embedded in the financial sector, and has played a major role in financial sector profitability and incomes since the late 1990s. In some cases, financial misbehaviour has supported truly grave offences (nuclear weapons proliferation), while in other cases it has been a major contributor to financial instability and recession (the S&L crisis, the Internet bubble).
And yet none of this conduct was punished in any significant way. Total fines for all these cases combined appear to be far less than 1 percent of financial sector profits and bonuses during the same period. There have been very few prosecutions and no criminal convictions of large US financial institutions or their senior executives. Where individuals not linked to major banks have committed similar offences, they have been treated far more harshly.
Given this background, it is difficult to avoid the conclusion that the mortgage bubble and financial crisis were facilitated not only by deregulation but also by the prior twenty years’ tolerance of large-scale financial crime. First, the absence of prosecution gradually led to a deeply embedded cultural acceptance of unethical and criminal behaviour in finance. And second, it generated a sense of personal impunity; bankers contemplating criminal actions were no longer deterred by threat of prosecution.
My own conclusion after having examined this subject is that if the Internet bubble, the abetting of frauds at Enron and elsewhere, and the money-laundering scandals had resulted in prison sentences for senior financial executives, the financial crisis probably would have been far less serious, even if financial deregulation had occurred just as it did at the policy level. The law still leaves considerable scope for dangerous and unethical behaviour, but many of the abuses of the bubble depended upon criminality.
And just as the last twenty years of unpunished crime constituted a green light for the bubble, so, too, the nonresponse to the bubble and crisis is setting the tone for financial conduct over the next decade. Beyond an interest in justice for its own sake, it is therefore important to consider whether the behaviour that generated the bubble was criminal, whether successful prosecutions are feasible under US law, and whether putting senior financial executives in prison on a large scale would be ethically justified and economically beneficial.
The Obama administration has rationalized its failure to prosecute anyone (literally, anyone at all) for bubble-related crimes by saying that while much of Wall Street’s behaviour was unwise or unethical, it wasn’t illegal. Here is President Obama at a White House press conference on 6 October 2011:
Well, first on the issue of prosecutions on Wall Street, one of the biggest problems about the collapse of Lehmans [sic] and the subsequent financial crisis and the whole subprime lending fiasco is that a lot of that stuff wasn’t necessarily illegal, it was just immoral or inappropriate or reckless. That’s exactly why we needed to pass Dodd-Frank, to prohibit some of these practices. The financial sector is very creative and they are always looking for ways to make money. That’s their job. And if there are loopholes and rules that can be bent and arbitrage to be had, they will take advantage of it. So without commenting on particular prosecutions—obviously that’s not my job; that’s the Attorney General’s job—I think part of people’s frustrations, part of my frustration, was a lot of practices that should not have been allowed weren’t necessarily against the law.35
In these and many other statements, the president and senior government officials have portrayed themselves as frustrated and hamstrung—desirous of punishing those responsible for the crisis, but unable to do so because their conduct wasn’t illegal, and/or the US government lacks sufficient power to sanction them. With apologies for my vulgarity, this is complete horseshit.
When the federal government is really serious about something—preventing another 9/11, or pursuing major organized crime figures—it has many tools at its disposal and often uses them. There are wiretaps and electronic eavesdropping. There are undercover agents who pretend to be criminals in order to entrap their targets. There are National Security Letters, an aggressive form of administrative subpoena that allows US authorities to secretly obtain almost
any electronic record—complete with a gag order making it illegal for the target of the subpoena to tell anyone about it. There are special prosecutors, task forces, and grand juries. When Patty Hearst was kidnapped by the radical Symbionese Liberation Army in 1974, the FBI assigned hundreds of agents to the case.
In organized crime investigations, the FBI and government prosecutors often start at the bottom in order to get to the top. They use the well-established technique of nailing lower-level people and then offering them a deal if they inform on and/or testify about their superiors—whereupon the FBI nails their superiors, and does the same thing to them, until climbing to the top of the tree. There is also the technique of nailing people for what can be proven against them, even if it’s not the main offence. Al Capone was never convicted of bootlegging, large-scale corruption, or murder; he was convicted of tax evasion.
In this spirit, here are a few observations about the ethics, legalities, and practicalities of prosecution related to the bubble:
First, much of the bubble was directly, massively criminal. One can debate exactly what fraction, where the grey areas are, how much of it can be proven, and so forth. But it sure as hell wasn’t zero. And we’ll take another little tour of the industry shortly, with this question in mind.
Second, if you really wanted to get these people, you could. Maybe not all of them, but certainly many. Some bubble-related violations are very clear, with strong written evidence. If you flipped enough people, some of them would undoubtedly have interesting things to say about what their senior management knew. And many of the people responsible for the bubble are the same people responsible for the other activities we just examined that have not been seriously pursued or punished. Some of these people have also committed various personal offences—drug use, use of prostitution, tax evasion, insider trading, fraudulent billing of personal spending as business expenses. Many of them still have their original jobs and are therefore subject to regulatory oversight and pressure, as are their firms. In fact, there are many techniques, venues, organizations, regulations, and statutes, both civil and criminal, available to investigate these people, punish them, and recover the money they took—if one really wanted to. The US government has used almost none of them.
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