A Toothless SEC Takes on Wall Street?

Kidney’s remarks come at an interesting time. Only several months after his halting comments, Eric Holder, the US Attorney General, decided to call his six-year tenure as head of the US Department of Justice a wrap. And just three days after Holder’s resignation became official a $40 billion class action lawsuit against the government for their so-called unlawful seizure of a majority stake in the insurance giant AIG during the 2008 Wall Street bailout began. It may seem like I’m rattling off isolated events that have nothing do with each other, but, if you look closely enough, it appears that traces of the ’08 Wall Street bust that left millions of Americans, not to mention much of the global financial system, in ruins are slowly making their way back into the media spotlight. Many Americans have put the economic collapse behind them, but for others it is impossible. As Jake Grovum of USA Today made clear in a 2013 article, “The deep and persistent losses of the recession forced states to make broad cuts in spending and public workforces. For businesses, the recession led to changes in expansion plans and worker compensation. And for individual Americans, it has meant a future postponed, as fewer buy houses and start families. Five years after the financial crash, the country is still struggling to recover.” Most Americans are familiar with the basic premise of the financial collapse. But, I bet if you asked Americans who was held responsible for the crash that left your mutual fund and retirement savings penniless, or left you without a job, or you without a house, they couldn’t give you an answer. And there’s a problem with that — a big, big problem —which is why its great that these traces of the Wall Street bust are once again trickling out into publicity. Because before we write-off Kidney’s remarks of the ineptness of government agencies as old news, or AIG’s lawsuit as the rich wanting more money, or Eric Holder’s tenure as a term defined by revolutionary civil justice, we must realize that we have another chance to place blame where blame is due, and has been due for six years. And that starts with financial institutions like AIG and ends with government agencies like the DOJ and the SEC.

First, a (relatively) brief of a history lesson. Most people have an idea of the actions the financial institutions took to create the big Wall Street crash of 2008, but an idea in the vaguest sense of the word. The banks did some very elaborate and dastardly things, and I can’t claim to completely understand every detail of the crash, but I can try to give you an overview of what I know. So basically, years before the ’08 crash, there’s this group of investors made up of institutions like pension funds, mutual funds, insurance companies, sovereign funds, etc. — really any place that people like you or I or your parents or their rich friends might be putting money for other people to invest and make us a profit. Traditionally, these investor groups make money by buying US treasury bills from the Federal Reserve, as these investments are AAA rated (meaning the safest investment) and usually have decent interest rates for a return on their investment. But, in the wake up of the .com bubble and the September 11 terrorist attacks, Federal Reserve Chairman (at the time), Alan Greenspan, lowered interest rates to a measly 1% in order to incentivize borrowing and keep the economy strong. Unfortunately for investors, this means no return on investment, but fortunately for banks on Wall Street, this means easy and cheap borrowing of money. This cheap borrowing allows banks to participate in large amounts of leverage, or essentially the borrowing of money to amplify the outcome of a deal. For example, if I buy one piece of paper worth $10 and turn around and sell that piece of paper to someone else for $12, I made a $2 profit. But, if I had $10 and borrowed $90 more dollars and then bought ten pieces of paper, I could turn around and sell those ten pieces for a total of $120. After I pay back the loan and the 1% interest rate on the loan (which would be 90 cents), I’d have a total profit of $19.10 (not including the original $10) instead of a profit of $2. With the extremely low interest rates, bank on Wall Street use this leverage technique and make a lot of money. But the investor groups want a piece of this action, because they no longer want to buy treasury bills from the FED for such a low return. So the banks have a great plan to make a lot of money from these investors. They decide to connect these investors to homeowners through the purchase of mortgages. Essentially, families that want to purchase houses save for a down payment on the house and then call a broker that connects them with a lender to lend them the rest of the cost of the house so they can purchase it. The money that lenders give to families is called a mortgage. The family pays the lender back over time, with payments every month. But investment bankers working at banks on Wall Street have this great idea: they decide to borrow lots of money and use leverage to buy a lot of these mortgages from lenders and package them in what is known as a collateralized debt obligations (CDO). This “debt obligation” is just a lot of different mortgages from different families that the banks have purchased from lenders. Now, instead of paying back mortgages to lenders, these families pay back their mortgages to banks on Wall Street. These CDOs are divided into three different slices: Safe slices, okay slices, and risky slices that investor groups will invest in. Think of the CDO as a cascade of money and the different slices as levels of a fountain. When the homeowner pays back their mortgage loans every month, this stream of money coming to the banks first goes to fill the safe slice (on the top of the fountain), then the okay slice, and whatever is left over fills the risky slice (on the bottom). If homeowners don’t pay back their mortgages and default, less money fulfills risky slice obligations (the reason why this is called the risky slice). Investors then decide what slice of the CDO they want to invest their money in. The safe slice has a small, but still higher interest rate than FED treasury bills, while the risky slice has a very high interest rate to make up for the uncertainty of return. Banks also insure the safe slice for a small fee through insurance companies (like AIG) called credit default swaps. They do this to make sure that credit rating agencies give the safe slice the safest rating (AAA). The okay slice receives a rating of BBB (which is good) and the risky slice doesn’t receive any rating. The insurance giant AIG offered up thousands upon thousands of credit default swaps, essentially insuring the safe mortgages if for some reason they were to default. But because AIG assumed these were rather safe, they didn’t think they would ever have to really pay the banks for mortgage defaults, and in effect were making tons of essentially free money from the purchase of these default swaps. Investor groups like mutual funds and pensions plans typically invest in the safe or okay slice, while risk takers like hedge funds invest in the risky slice. These investors are making more than they would from treasury bills. The bankers then repay their loans and make a big profit. Insurers like AIG make big bucks for free. Everyone is happy. Everyone wants more CDOs to invest in.

The investment banker calls up the lender and tries to buy more mortgages. But eventually, there are no more mortgages to sell, because all of the families that qualify for a mortgage already have one. But the lenders and bankers have another great idea. If homeowners default on mortgages, the owner of the mortgage gets to keep the house. And housing prices (at this point) have always been on the rise. So lenders figure that they are covered if the homeowners don’t pay back their mortgages because either they’ll be able to resell a house that’s increasing in value, or pass it on to a banker that will buy the mortgage. For mortgage loans, these lenders no longer require a down payment, proof of income, or really any documents at all. They now are lending to predominantly irresponsible homeowners, creating sub-prime mortgages. Banks, knowing full well that they were buying sub-prime mortgages from lenders, started packaging these bad mortgages into CDOs and selling them to investors. This worked for a while, but eventually (as one may have guessed), these irresponsible homeowners start defaulting in large numbers. Because the bankers own the mortgages in the CDOs, instead of monthly payments, they start turning into houses. This would be fine, except there are so many defaults that there are now thousands upon thousands of houses in the market that the banks are trying to sell off. There is more supply in the housing market than demand, and housing prices start to drop. Even responsible homeowners who pay back their mortgages notice that the value of their home is falling below the cost of their mortgage, so they walk away from their homes and decide to sell, too. At this point, investors know that the CDOs are a worthless investment because there is no source of income, even for safe slices. Banks turn to insurers like AIG to receive the payments for the credit default swaps, but AIG, never actually expecting to pay out money for large amounts of defaults (in this case large, large amounts of defaults), has no way to meet their contracts and are on the brink of bankruptcy. The banks now have no way to pay back the millions of dollars they borrowed for the leverage to package these CDOs, and start going bankrupt quickly. Investors, although they stopped buying into CDOs, already own thousands. The money that the investors used — money from mutual funds or pension funds or retirement funds — is all gone. Lenders want to sell more mortgages to banks, but bankers wont buy anymore, leaving brokers out of work. The whole system has collapsed. More reading can be done here if you’re a real sucker for this kind of stuff.

So the whole financial system collapsing, even in its most basic form, is not as basic as one would think. But who was behind it? Financial institutions such as Goldman Sachs, Lehman Brothers, J.P. Morgan, Bank of America — these institutions aren’t inherently corrupt. Rather, it’s the individuals within them that partake in these corrupting actions that ultimately corrupt the institutions. And there are a lot of individuals here that did some pretty awful things. Just as an examaple, the blatantly corrupt actions taken by individuals working within J.P. Morgan Chase offer up a great example of the industry-wide norms. There’s a great article published by Matt Taibi for the RollingStone earlier this month that everyone should read. But just to give you the gist of some of the actions taken by these banking institutions: Before the ’08 crash, Chase hired a new manager for diligence, the group in charge of reviewing and clearing loans. Upon his arrival, this manager ordered his employees to stop sending him e-mails, wary of putting anything in writing when it came to these mortgage deals. According to the article, “one former high-ranking federal prosecutor said that if he were taking a criminal case to trial, the information about this e-mail policy would be crucial. ‘I would begin and end my opening statement with that,’ he says. ‘It shows these people knew what they were doing and were trying not to get caught.’” In 2006, not long after the email policy was implemented Taibi’s source, Alayne Fleischmann who worked as a security lawyer for the bank, was asked to evaluate a packet of home loans from a mortgage originator named GreenPoint, worth $900 million collectively. But almost immediately, Fleischmann and her co-workers realized striking problems with the loans. They noted that these mortgages loans were particularly old, as most loans are purchased by banks and packaged in CDOs within two or there months. These loans purchased by Chase were seven or eight months old, meaning these loans had already been rejected by Chase or another bank, or that these loans were “early payment defaults,” or loans that had already been sold to a bank but have been returned after homeowners have missed multiple payments. Taibi asserts that these loans were, “the very bottom of the mortgage barrel. They were like used cars that had been towed back to the lot after throwing a rod.” But as Taibi writes, “As Chase later admitted, it not only ended up reselling hundreds of millions of dollars worth of those crappy loans to investors, it also sold them in a mortgage pool marketed as being above subprime, a type of loan called ‘Alt-A.’ Putting these bad loans in an Alt-A security is a little like putting a fresh coat of paint on a bunch of junkyard wrecks and selling them as new cars.” Fleischmann and other reviewers raised concern, but when objections were brought up, the number-crunchers who had been complaining about the loans suddenly began changing their reports. According to Fleischmann’s account, “The process is strikingly similar to the way police obtain false confessions: The interrogator verbally abuses the target until he starts producing the desired answers. ‘What happened,’ Fleischmann says, ‘is the head diligence manager started yelling at his team, berating them, making them do reports over and over, keeping them late at night.’ Then the loans started clearing.”

Obviously there’s a problem here. Actually there’s more than a problem, there’s loads of incredibly illegal and unethical activity. Sure, investors probably shouldn’t have been naive enough to assume that there was an endless supply of prime-rate mortgages. But the bank’s sale of mortgages they knew full well would assuredly end with default, and at the same time lying to investors and calling these loans something that they weren’t is fraud. Taibi states, “This moment illustrates the most basic element of the case against Chase: The bank knowingly peddled products stuffed with scratch-and-dent loans to investors without disclosing the obvious defects with the underlying loans.” In 2010, Chase CEO Jamie Dimon testified before the Financial Crisis Inquiry Commission, playing off how the bank had been duped like every other institution on Wall Street. “In mortgage underwriting,” he said, “somehow we just missed, you know, that home prices don’t go up forever.” It’s a sad story, but it’s not a unique one. J.P. Morgan Chase wasn’t alone in their actions. All of the large banks were doing the same thing to make big money.

And the worst part: there was nothing stopping them. Security regulation agencies like the Federal Deposit Insurance Corp (FDIC), the Office of the Comptroller of the Currency (OCC), the Commodities Future Trading Commission (CFTC), and the Securities and Exchange Commission (SEC) are all in place to catch and investigate financial criminals. Unfortunately, lenient regulations and the “revolving door” politics that Kidney brings to light in his retirement speech prove that even if government agencies exist to bring about financial justice, justice isn’t always served — in fact it rarely is.

Here’s how the regulation and prosecution is designed to come about: Regulatory agencies like the SEC watch for financial violations. When they notice something or are tipped off by the New York Stock Exchange, the SEC’s army of 1,100 financial investigators use their expertise to begin to make a case against the violators. Because the SEC has no prosecutorial power, they then deliver the case to the Department of Justice, and, as Taibi explains in a Febuary 2011 article (seriously you should read this guy’s stuff), the DOJ “perp-walks the Asshole out of Nobu, into a Crown Victoria and off to 36 months of push-ups, license-plate making and Salisbury steak.” In theory, this is the process. In reality, the SEC and Holder’s administration in the DOJ provided no justice here. The SEC chairmen are too worried about their return to Wall Street to make any big moves against the financial big shots. As Kidney states, “If you employ somebody whose goal is to return to Wall Street, you’re going to get a different kind of enforcement than from somebody who’s willing to make a career out of tough regulations.” And the DOJ, well there’s a whole other problem in itself.

Attorney General Eric Holder came into office in 2009 with a focus on financial fraud. Upon Holder’s nomination, a Justice Department spokesman, Matthew A. Miller, commented “It will be a top priority of the Justice Department to hold accountable executives who have engaged in fraudulent activities.” Boy, that kind of ambition went down the drain quickly. Since the ’08 crash, I wonder if you can guess how many Wall Street or mortgage executives have had a criminal charge brought against them? Maybe 50? Okay a little ambitious. Well 25 isn’t too many, right? Hopefully at least 10. In reality—zero. No executives anywhere have ever been prosecuted for their obvious crimes against the American financial system for their part in the 2008 crash. Hopefully now you’re asking: where the hell was the DOJ during the last six years?! Your guess is as good as mine. Instead, these banking investigations by the SEC and DOJ have all led to civil settlements. In August, Bank of America agreed to pay $16.65 billion to the DOJ in their role selling toxic mortgages. In July, Citigroup agreed to pay $7 billion, and last November, J.P. Morgan agreed to pay $13 billion to resolve their own mortgage investigations. In April of 2010, the SEC, in a surprising move actually charged Goldman Sachs with fraud over the marketing of its subprime mortgages. But in an unfortunate, and much less surprising, series of events, Goldman settled with the SEC for a measly $550 million within a matter of weeks. These multi-million or billion dollar settlements may seem like a real deterrent for the future, but, for example, when you realize that Goldman Sachs has $913 billion in assets, $550 million seems more and more like a drop in the bucket. And too make the situation even worse, the people who committed the crimes aren’t the ones actually paying the fines. Banks caught defrauding their shareholders often use shareholder money to foot the tab of justice. According to Jed Rakoff, a federal judge in New York’s Southern District, “it’s management buying its way off cheap, from the pockets of their victims.” And as Taibi writes, “To understand the significance of this, one has to think carefully about the efficacy of fines as a punishment for a defendant pool that includes the richest people on earth — people who simply get their companies to pay their fines for them. Conversely, one has to consider the powerful deterrent to further wrongdoing that the state is missing by not introducing this particular class of people to the experience of incarceration.”

Holder’s justification for the lack of prosecution: banks are too big to jail. In March of last year, Holder made his opinions on financial justice very clear: “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute — if we do bring a criminal charge — it will have a negative impact on the national economy, perhaps even the world economy,” Mr. Holder told the Senate Judiciary Committee. Holder feared that indictments could jeopardize the financial system. Of course, Holder later rescinded his comments, claiming that in actuality he meant: “there’s no institution, there’s no individual who cannot be investigated and prosecuted by the United States Department of Justice.” But that doesn’t mean much considering he hasn’t actually used his power to prosecute any deserving criminals in this case. According to an operative who spoke to Business Insider about Holder’s time as attorney general, “He could not have been more of a disappointment in terms of dealing with the issues that led to the collapse of the financial markets and the global economy. He had an opportunity and, frankly, a responsibility to say there was a whole host of systemically illegal and improper behavior and to go after it.” And in the end, it seems that Kidney’s comments about the SEC have defined Holder’s financial justice record: “On the rare occasions when Enforcement does go to the penthouse, good manners are paramount. Tough enforcement – risky enforcement – is subject to extensive negotiation and weakening.”

By now it’s probably no wonder why the AIG lawsuit against the government, led by Hank Greenberg, head of Starr International Co (AIG’s largest shareholder at the time of the bailout) and former AIG CEO, is a laughable. AIG feels like the government, in their purchase of AIG equity to prevent the company’s collapse, was too harsh, and the terms of their loan to AIG was far tougher than those applied to the big banks. This is probably true, and what makes this whole situation one big joke. AIG partook in risky betting of mortgage futures and lost. The government wasn’t forced to bailout the insurance giant — they did so to prevent a financial collapse on Wall Street. The shareholders could have been left with nothing if AIG had gone bankrupt. Instead, they were left with something. But, after Holder and the SEC’s negotiations with Wall Street after the crash, even this seems unusually harsh. The lawsuit is one big slap in the face to financial justice. It’s a classic case of adding insult to injury. And what of Holder’s legacy as attorney general. Sure, Holder’s civil rights history is commendable (in fact, I applauded Holder’s actions against Texas voting rights legislation in an article earlier this year), but what are civil rights worth if bankers on Wall Street can take your hard-earned money whenever they want without redress? We already know what kind of message this leniency sends to Wall Street: one that incentivizes corruption instead of preventing it. But what message does it send to prospective students looking for a career in finance? A lot of the brightest people I’ve met here at Brown plan to go into finance. Even I’m interested in a job in the field (although I don’t know how likely it is I’ll be hired after this article). So what is Holder telling us? We can do whatever it is that will make us richest, even if that means breaking the law or ruining the lives of millions of Americans in the process? So I’m glad Holder’s resignation coincides with Kidney’s statements and AIG’s lawsuit. Because when it comes to financial justice in all of these cases, a former Senate investigator said it best: “Everything’s f%@#*d up, and nobody goes to jail.”