Third, the moral argument for punishment is very strong, providing ample justification for erring on the side of aggressive legal pursuit. Whatever portion of banking conduct during the bubble was criminal, it was certainly substantial, and there is no doubt whatsoever that it was utterly, pervasively unethical, designed to defraud in reality if not in law. Since the crisis, the people who caused it have been anything but honest or contrite. They have often been evasive, dishonest, and self-justifying, returning as quickly as possible to their unerringly selfish behaviour. Their behaviour caused enormous damage, both human and economic; the consequences of their wrongdoing are so large as to justify almost any action that could help to prevent another such crisis by creating real deterrence. There would also be intangible but large benefits to raising the general ethical standard of a vital industry, and one whose executives often become high-level government officials.
Given this background, let’s now consider the question of criminal liability, as well as the feasibility of prosecution.
J’accuse
A REASONABLE LIST of prosecutable crimes committed during the bubble, the crisis, and the aftermath period by some financial services firms includes:
• Securities fraud (many forms)
• Accounting fraud (many forms)
• Honest services violations (US mail fraud statute)
• Bribery
• Perjury and making false statements to US federal investigators
• Sarbanes-Oxley violations (certifying false accounting statements)
• RICO (Racketeer Influenced and Criminal Organizations Act) offences and criminal antitrust violations
• Federal aid disclosure regulations (related to Federal Reserve loans)
• Personal conduct offences (many forms: drug use, tax evasion, etc.)
In addition, financial sector firms and executives committed many civil offences for which they could be pursued in civil actions, which have a lower burden of proof (a preponderance of evidence, as opposed to “beyond a reasonable doubt” required in criminal judgements). These offences include civil Sarbanes-Oxley violations, civil fraud, and violations of multiple SEC regulations, particularly regulations related to disclosure requirements.
Let’s consider some examples.
Securities Fraud
Here, we face an embarrassment of riches. The primary applicable authority is US Rule 10b-5, promulgated by the SEC under the authority of the 1934 Securities Exchange Act. It reads:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
There are several essential elements to a 10b-5 offence: it must be a misstatement or omission that is sufficiently material to affect an investor’s opinion; that is made intentionally; that the investor relied upon in making his decision; and that directly caused actual losses. The rule can be used by the SEC for bringing civil cases, by the US Justice Department for both civil and criminal actions, and also by private parties bringing civil suits. Even if the securities in question are being sold to sophisticated, professional investors, you can’t lie to them.
Where to begin?
As we have already seen, almost all the prospectuses and sales material on mortgage-backed bonds sold from 2005 through 2007 were a compound of falsehoods. But it starts even earlier in the food chain. We have also already seen that mortgage originators committed securities fraud when they misrepresented the characteristics of loan pools, and the nature and extent of their due diligence with regard to them, when they sold pools to securitizers (and accepted financing from them). Most or all of the securitizers (meaning nearly all the investment banks and major banking conglomerates) then committed securities fraud when they misrepresented the characteristics of loans backing their CDOs, the characteristics of the resulting mortgage-backed securities, and the nature and results of their due diligence in the process of creating those CDOs. The securitizers also committed securities fraud when they made similar misrepresentations to the insurers of, and sellers of CDS protection on, those CDOs.
The executives of both originators and securitizers then committed a separate form of securities fraud in their statements to investors and the public about their companies’ financial condition. They knew that they were engaging in fraud that would eventually need to end, and as the bubble peaked and started to collapse, they repeatedly lied about their companies’ financial condition. In some cases they also concealed other material information, such as the extent to which executives were selling or hedging their own stock holdings because they knew that their firms were about to collapse.
Next, several investment banks committed securities fraud when they failed to disclose that they were selling securities that they had designed to rid themselves of their worst loans and CDOs, or that were designed to fail so that the investment banks and their hedge fund clients could profit by betting on their failure. The Hudson and Timberwolf synthetic CDOs sold by Goldman Sachs, and which were the focus of the Levin Senate subcommittee hearings, provide a very strong basis for prosecution. Goldman’s trading division had been dragooned into finding and offloading their riskiest assets to naive institutional investors—midsized German banks, South Korean banks, minor public pension funds, and the like. Important representations in the Hudson sales material—that assets were not sourced from Goldman’s own inventory—were distorted, in ways that could be material, since investors had learned to be wary of banks clearing out their own bad inventory. E-mail trails show that top executives closely tracked the disposals and were relieved when they managed to sell the Timberwolf assets—as they should have been, for the assets were nearly worthless within months. There have been no prosecutions.
Many large US financial institutions, including the banks but also accounting firms, rating agencies, and insurers, were involved in other securities frauds during the bubble. We have already noted the banks’ misrepresentations as to the safety and liquidity of auction-rate securities, for example, for which nobody has been prosecuted criminally. Similarly, Citigroup failed to disclose in its investor presentations that it was contractually obligated to repurchase, or pay for the losses on, huge quantities of securities that it had placed in off-balance-sheet structured investment vehicles (SIVs). (In this case, Citigroup may have a legal defence—while its investor presentations were misleading, Citigroup did disclose the existence of SIV-related liabilities in the footnotes of the 10-K reports it filed with the SEC.) Similarly, AIG and the other mortgage securities insurers were also highly dishonest in their representations to the investing public when, as the bubble peaked and started to collapse, they faced imminent financial disaster.
In some cases, we have clear evidence of senior executive knowledge of and involvement in misrepresentations. For example, quarterly presentations to investors are nearly always made by the CEO or CFO of the firm; if lies were told in those presentations, or if material facts were omitted, the responsibility lies with senior management. In some cases, such as Bear Stearns, we have evidence from civil lawsuits that very senior executives were directly involved in constructing and selling securities whose prospectuses allegedly contained lies and omissions. In other cases, we do not yet have direct evidence of senior executive involvement, but such involvement is quite possible. If prosecutors forced the people directly responsible to talk, there is no question whatsoever in my mind that many of them would implicate senior management. There are
several reasons for believing this. First, the amounts of money involved were so large. Second, most firms required senior management to approve issuance of major securities. And third, the senior management of several securitizers was dominated by people who, earlier in their careers, had been deeply involved in similar activities, and who would be expected to monitor them closely and understand them.
Accounting Fraud
Here we also have a number of known opportunities for prosecution, as well as many other likely ones. We have already seen, of course, that both Fannie Mae and Freddie Mac allegedly engaged in massive accounting frauds for years until their discovery in 2003–2004. Those frauds resulted in no criminal prosecutions, and only mild civil penalties; some of the individual beneficiaries were able to keep their illicit proceeds, and none were fined more than their illicit gains. The statute of limitations on those offences has now expired.
However, we also know of other major probable violations. The best known is the “Repo 105” trick by which Lehman Brothers fraudulently concealed its real level of leverage during the bubble. Lehman’s US accounting firm, Ernst & Young, allegedly shielded themselves by insisting that Repo 105 deals be nominally run through an international subsidiary, and thus the transactions would not be included in consolidated US numbers. Ernst & Young denies any wrongdoing and states that it followed all US rules. In late 2010, the New York State attorney general brought a civil suit against Ernst & Young, which the firm said it would “vigorously defend”, but nobody has been prosecuted or fined for the Repo 105 deals.36
Lehman and many other securitizers also inflated the value of their assets. In Lehman’s case, the most egregious overvaluation was in its commercial property portfolio, whose overvaluation by billions of dollars was discussed explicitly by Lehman senior management in the year prior to the firm’s collapse. Other firms such as Merrill Lynch and Citigroup inflated the value of their mortgage-related assets—loans waiting to be securitized, CDOs waiting to be sold, pieces of CDOs that they could not sell or had decided to retain. We have already seen, for example, that Merrill Lynch traders paid traders in another Merrill Lynch group to “purchase” mortgage securities at inflated prices when they could not be sold on the open market. In a number of cases, these overvaluations were known and discussed within the firm; and again, some degree of senior management involvement would often be likely. Again, nobody has been prosecuted.
Joseph Cassano and AIG’s senior financial management aggressively prevented Joseph St. Denis from properly evaluating the CDS portfolio of AIG Financial Products after AIG’s auditor had declared a material weakness in AIG’s financial statements. Both Cassano and AIG senior management also made a number of extremely inaccurate, misleading public statements to investors and investment analysts in 2007 and 2008. AIG continued to maintain inflated values of its CDS and mortgage securities positions in late 2007 and the first half of 2008, even though Goldman Sachs was sharply reducing its own valuations of mortgage securities and was demanding and obtaining large amounts of CDS collateral from AIG. There have been no prosecutions related to this situation.
It seems highly unlikely that the banks’ accounting firms were never aware of these frauds. In several cases, such as the Repo 105 fraud and AIG’s accounting for its CDS portfolio, there already exists public evidence that accounting firms realized at the time that fraud was being committed. However, there has not been a single criminal prosecution of a US accounting firm related to the bubble.
Honest Service Violations and Bribery
The 1988 amendments to the US mail fraud statute include the following: “scheme or artifice to defraud includes a scheme or artifice to deprive another of the intangible right of honest services.” This statute has been used to prosecute many corruption and financial fraud cases. A recent Supreme Court decision found that the statute was unconstitutionally vague, and limited its application to cases involving bribes or kickbacks.
However, several cases would still seem to fit. Yield spread premiums, authorized and even ordered by the senior management of originators, certainly led to massive violations of any right to honest services. Some of those lenders were owned by the banks, and others were undoubtedly pressured or incented by the banks to provide larger quantities of higher-yielding loans. There have been zero bubble-related honest services prosecutions of lenders or senior executives of lenders. Based on the SEC/General Accounting Office investigation, the Jefferson County case involves, first, under-the-table fees paid by JPMorgan Chase to county officials but, even more interestingly, the same sort of payments to Goldman Sachs to induce Goldman not to bid on the project. Nobody at JPMorgan Chase or Goldman Sachs has been prosecuted.
Finally, the rating agencies would seem to be ripe for honest services prosecutions, even within the recently narrowed scope of the statute. While their free speech defence under the first amendment of the Bill of Rights might protect the rating agencies from many forms of civil liability, it does not protect them from criminal liability. With varying degrees of nakedness, all three of the major rating agencies provided questionable services to investors. Many times they slanted their ratings to favour issuers who paid them; failed to disclose the extent to which they were paid consulting fees by those issuers; failed to disclose that senior management was pressuring employees to rate unreasonably large numbers of securities, precluding any effective due diligence; failed to disclose that when offered information (for example by Clayton Holdings) that would have improved the accuracy of ratings, they refused the information; and represented that they were actually providing unbiased ratings services when, often, they were simply providing assembly-line high ratings for securities, many of which were later found to be fraudulent. However, there has not been a single criminal prosecution, either for honest services violations or any other offence, of any of the major rating agencies or their executives.
Perjury and Making False Statements to Federal Investigators
It is felony perjury to lie under oath, whether in a civil deposition, in a civil trial, or when testifying before the US Congress. It is also a felony to lie to US federal investigators.
Here, many cases might be difficult to prove, but the blunt reality is that many financial executives did not tell the whole truth while testifying before Congress. Angelo Mozilo testified that it was not in his or his executives’ interest to make fraudulent loans, when in fact we have seen, and Mr Mozilo evidently knew, that it was in his financial interest to do this, even if it destroyed his firm.
Then there was Lloyd Blankfein. Lloyd Blankfein testified, for example, that he was unaware of the importance that ratings played in the purchasing decisions of institutional investors. Blankfein had spent his entire career at Goldman Sachs (since 1981) in commodities and securities trading. For most of the decade before he became CEO, he was a senior executive in the Goldman Sachs division that included its fixed-income (bond) business. The idea that he was unaware of the importance that ratings played in institutional purchases of CDOs is, to put it frankly, absurd. I would not be surprised that if someone should take the effort to go carefully through Mr Blankfein’s e-mail and depose everyone around him, there would be plenty to indicate that he knew how important these ratings are. His testimony before Senator Levin’s committee was also curious in maintaining that Goldman was “market making” when in fact it was knowingly selling off its junk and betting against the resultant securities that it constructed and sold for this purpose. His colleagues’ testimony was, if anything, worse—Dan Sparks saying that he sold Timberwolf before it was described as a “shitty deal” and then admitting literally ten seconds later, when nailed by Senator Levin, that, yes, they had sold it afterwards too.
To take another example, this time from the hearings of the Financial Crisis Inquiry Commission (and yes, this was sworn testimony), here is former Citigroup CEO Chuck Prince in an exchange with a commission member questioning him and Robert Rubin:37
EXAMINATION BY COMMISIONER MU
RREN
COMMISIONER MURREN: You mentioned capital requirements are very important. Did Citigroup ever create products that were specifically designed to avoid capital requirements?
MR RUBIN: I don’t know the answer to that.
COMMISIONER MURREN: And you, Mr Prince, would you create a product simply to—or at least one of the principal reasons for designing the product was to avoid capital requirements?
MR PRINCE: I—I think the answer is no because the product would have to be designed as something that a client would want. In other words, you wouldn’t create a product that was internally focused. If your question is, would the—would the team create products—and in the course of creating the products, try to minimize capital burdens, my guess is the answer is yes, but I don’t know for sure.
COMMISIONER MURREN: So then it wouldn’t surprise you to know that in the minutes of one of your meetings that specifically relate to the creation of new products, in this instance, it would be liquidity puts, that there was a notation that specifically referenced the fact that this type of structure would avoid capital requirements?
MR PRINCE: I have no way of responding without seeing the document and understanding the context of it.
“Liquidity puts” were the mechanism by which Citigroup guaranteed that it would absorb losses on mortgage securities placed in off-balance sheet SIVs. The SIV–liquidity put mechanism had no legitimate economic purpose; it existed solely for the purpose of allowing Citigroup to misrepresent its balance sheet, and to conceal the fact that Citigroup retained the real risks associated with the potential failure of the securities.
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