Washington Lawyer

Great Recession: Where’s the Punishment After the Crime?

From Washington Lawyer, May 2014

By Anna Stolley Persky

Lehman Brothers sign, photo by Cate Gillon/Getty ImagesLess than six years ago, the U.S. and world banking systems teetered on the edge of collapse.

In September 2008, global financial services firm Lehman Brothers Holdings Inc. filed for bankruptcy, pushing the weakened U.S. economy into a downward spiral. An already shaky housing market plummeted. The country, along with the rest of the world, entered into what has been dubbed the “Great Recession.”

As with past financial crises, the Great Recession is a cautionary tale about the excesses of greed. With the benefit of hindsight, analysts have blamed the fallout on a number of factors, including massive corporate mismanagement and what some market observers have described as practically unbridled risk-taking by banks and investors. Specifically, analysts have focused on the multilayered practice of packaging and selling toxic mortgage loans to investors, and then recklessly betting on the securities backed by the loans.

“There was optimism, if not hubris, about risk-taking,” says Jeffrey Manns, an associate professor of law specializing in securities regulation at The George Washington University Law School in Washington, D.C. “There were many actors who had assumptions about the future of the housing market that simply were not valid. There’s a certain amount of truth to the term ‘irrational exuberance.’ Everyone was excited about the housing market, and nobody wanted to take the punchbowl away from the party.”

Rounding Up the Wrongdoers
The U.S. Department of Justice has been investigating whether individuals and entities involved in toxic, collateralized mortgage-backed securities can be charged with crimes. But, as yet, there have been no criminal convictions of high-level corporate officials directly linked to the practice.

Michael Greenberger, former director of the U.S. Commodity Futures Trading Commission’s Division of Trading and Markets, says the Obama administration needs to step up and press charges against those involved in toxic mortgages.

“The American public as a whole expected there would be accountability for upending the economy,” says Greenberger, now a law professor at the University of Maryland Francis King Carey School of Law. “There hasn’t been, and common sense tells us that the taxpayer is angry about this.”

On the other hand, the Justice Department, along with other agencies, has successfully held investment banks civilly responsible. JPMorgan Chase & Co. and other banks have agreed to pay millions or even billions of dollars to settle allegations they knowingly bundled toxic loans and then sold them to unsuspecting investors. As part of JPMorgan’s record-breaking $13 billion settlement, the bank admitted to making “serious misrepresentations” to investors.

But some critics, including an outspoken federal judge in the Southern District of New York, say the department’s failure to bring criminal charges against high-level individuals at investment banks depicts weakness in the prosecutorial system. Manns also thinks prosecutors are failing to deter the next generation of potential financial criminals.

“We are now seeing large dollar settlements but very little individual accountability,” says Manns. “If individuals aren’t held accountable, it’s not clear that there will be much deterrence. What’s the worst that happened to folks who engaged in dubious activities? They made money, they were bailed out, and now they have retired in places like Boca Raton.”

Former federal prosecutor Aitan D. Goelman says the Justice Department “has acutely felt the pressure and public desire for accountability on this issue.”

“There’s been a lot of attention and resources devoted to looking for fraud cases,” says Goelman, now a partner in the Washington, D.C., office of Zuckerman Spaeder LLP. “But they have to prove criminal intent, and that can be difficult. If there were low-hanging fruit cases that could have been brought and won, they would have been brought. Prosecutors can only go where the evidence and law leads them.”

According to the Justice Department and other government agencies, investigations relating to the mortgage-backed securities market remain open. Justice Department officials describe prosecutors as dedicated to pursuing justice in all their financial crimes cases. Spokesperson Ellen Canale says the department has aggressively pursued a “range of complex and sophisticated financial fraud cases, and a number of major investigations are still ongoing.”

Since fiscal year 2009, the Justice Department has filed nearly 16,000 financial fraud cases against more than 23,000 individuals. More than 4,000 of the defendants were involved in mortgage fraud cases.

In her 2013 testimony before the Subcommittee on Oversight and Investigations of the U.S. House of Representatives’ Committee on Financial Services, Mythili Raman, former acting assistant attorney general for the Justice Department’s Criminal Division, said the agency is “deeply committed to holding wrongdoers—whether individuals or business entities—to account for their crimes.”

Some legal observers say it is preferable for prosecutors restrain themselves rather than throw caution to the wind. Jacob S. Frenkel, chair of the securities enforcement, white-collar crime, and government investigations practice at Shulman, Rogers, Gandal, Pordy & Ecker, P.A., points out that aggressive prosecutors who charge without enough evidence to back up their allegations end up “with their backsides handed to them.”

“The effect of a successful criminal prosecution is a deterrence message,” Frenkel says. “Certainly the right case with a government-favored outcome can send a powerful deterrent message. But at the same time, acquittals also send a message.”

The Price of Risky Dealings
The problems with toxic mortgages predate 2008 and involve what experts describe as risky practices relating to the derivatives market. One major issue, experts say, is that mortgage brokers pursued risky borrowers whom banks then approved.

Before the 21st century, it was customary for U.S. banks to exercise due diligence when considering lending money for a mortgage. Due diligence meant investigating an applicant’s history and financial stability, including income, debt, and credit rating. And sometimes applicants were turned away.

But after years of low inflation and relatively stable economic growth in the United States, the housing market appeared particularly lucrative. In response, U.S. banks relaxed their standards for potential borrowers. Mortgage brokers began to pursue even the riskiest of borrowers for loans, encouraging potential homeowners to seek out mortgages with payments that would be, in fact, difficult for them to pay off under the best of circumstances. 

Perhaps emboldened by a booming housing market, borrowers sought mortgages that were arguably above their means, often with adjustable, instead of fixed, mortgage rates.
“First, individuals getting mortgages were willing to enter into bargains that may not have been in their best interest,” says Manns. “And mortgage brokers, who should have acted as gatekeepers, weren’t.”

In the meantime, banks approved risky mortgages and then sold them to other banks, which then assembled the loans into pools. Investors, always looking for creative ways to make money, turned to the concept of pooled mortgage-backed securities. The over-the-counter derivatives market was considered particularly inviting because it was less regulated than more formal exchanges.

All types of investment banks were involved in buying and selling collateralized mortgage-backed loans. And while private institutions drove the initial market, Fannie Mae, Freddie Mac, and the Government National Mortgage Association, known as Ginnie Mae, also became involved in mortgage-backed securities.

Ginnie Mae is a government-owned corporation that guarantees bonds backed by government-guaranteed home mortgages. Fannie Mae and Freddie Mac also guarantee bonds backed by mortgages, but these mortgages are not backed by government guarantees. Fannie Mae and Freddie Mac are not government-owned, but publicly traded companies.

“Part of the story is that Fannie Mae and Freddie Mac didn’t want to be left behind either,” says Manns.

Some experts claim that the participation of all three entities—Fannie Mae, Freddie Mac, and Ginnie Mae—in the collateralized mortgage-backed securities frenzy contributed to the depth of the financial crisis. According to experts in the financial industry, banks felt comfortable granting loans to subprime borrowers because once those loans were issued, they were promptly sold to other entities that thereafter assumed the risk if buyers defaulted.

“With collateralized debt obligations, banks had little, if any, risks involved,” says Manns. “They didn’t have the economic incentive to scrutinize these mortgages the way they normally would have.”

At first, investors sought out collateralized mortgages because they provided high returns in a time of low interest rates.

“Investors bought the collateralized debt obligations without knowing quite what they were buying. They were buying partly in faith based on the reputation of the bank selling and partly in hubris,” says Manns. “And because mortgage-backed securities were so lucrative for a period of time, investors worried that if they didn’t invest, they wouldn’t make as much as their competitors and they would be left behind.”

Years later, the Financial Crisis Inquiry Commission, tasked with examining the causes of the country’s economic crisis, accused financial institutions of greedy risk-taking, saying that “[l]ike Icarus, they never feared flying ever closer to the sun.”

“We just see this pattern over and over where society becomes convinced that something is the cat’s meow. Enthusiasm encompasses everyone, even the regulators,” says Edmund W. Kitch, a professor at the University of Virginia School of Law where he specializes in securities fraud and regulatory law. “It’s really hard in that environment for people to say ‘the party’s over’ even when it is actually over.”

When the economy tanked, many of the riskiest homebuyers had purchased adjustable-rate mortgages, and so, once interest rates went up, these homeowners, along with others, defaulted on their loans. Mortgage-backed securities declined in value. The fact that toxic mortgages were pooled did not, in the end, provide investors with protection.

It became difficult to sell mortgage-backed assets or to use them as collateral for short-term funding. Financial institutions that needed loans couldn’t get them. The result was a “liquidity crisis” as many financial institutions lacked the reserves to operate without borrowing.

On September 15, 2008, the investment banking firm Lehman Brothers filed for Chapter 11 protection in the largest bankruptcy to date in U.S. history. The Dow Jones plummeted 504.48 points, its largest one-day drop since the aftermath of the September 11 attacks.

At that point, investors holding large portfolios of collateralized debt obligations found that they were facing enormous losses. Entities that had been swapping collateralized debt obligations had not kept enough money in reserve to absorb sudden losses. When insurer American International Group Inc. stood on the brink of collapse, the public recognized that the country was sliding into financial chaos.

“It’s a fairly accepted insight that had it only been about mortgage-backed securities, we would have gotten through it,” says Donald C. Langevoort, who teaches securities regulation at Georgetown University Law Center in Washington, D.C. “But when a system gets overleveraged, it only takes a small bump to destabilize things. Banks were playing with borrowed money so much that they couldn’t absorb the losses.”

Negotiation, Regulation
Along with further regulation, the Obama administration has engaged in civil wrangling and large civil settlements with investment banks. In the past few years, the government has announced a series of civil settlements with investment banks, including Citigroup Inc. and Wells Fargo Bank.

“The Justice Department and the [U.S. Securities and Exchange Commission] decided on a strategy of pursuing civil liability against entities as opposed to holding individuals accountable in monetary or criminal ways,” says Manns. “The question is, is this a strategy designed for optics or effective deterrence?”

States such as New Jersey and New York also have been delving into conduct regarding toxic mortgage-backed securities.

Outside legal experts note that of late the federal government, when negotiating with companies over civil settlements, has pushed to leave intact the government’s ability to later pursue criminal charges, if warranted. In the past, similar settlements often included a release of criminal liability.

In addition, the SEC has been pushing for admissions of wrongdoing by companies seeking to settle civil claims. In general, the SEC has been changing its rules on the extent to which companies admit to the charges when seeking settlements.

For example, in November 2013, when the Justice Department and its federal and state partners, including the SEC, secured a $13 billion settlement from JPMorgan over abuses in mortgage-backed securities, the financial services company also admitted to making “serious misrepresentations” to investors. JPMorgan stated that it “continues to cooperate” with the ongoing criminal investigation, while the Justice Department said the settlement would not release the firm or any individuals from potential criminal prosecution.

After the settlement, however, bank executives pointed out during a conference call to analysts that there were no admissions to any specific violation of the law.

But Greenberger, the University of Maryland law professor who teaches a course on futures, options, and derivatives, says “this new refusal to bargain away criminal investigations has got to be scaring banks into looking carefully at their conduct.”

Some legal experts see as problematic the SEC’s efforts to negotiate settlements with companies while pushing for admissions of wrongdoing, and yet reserving the right for a later criminal probe. Will the SEC start pushing for specific admissions? How far can it go and how will these civil admissions affect a company’s liability and any subsequent criminal probes?

“We are going through a change with the SEC, where it is starting to say there must be an admission of liability. But liability to whom and about what?” asks Langevoort. “But the nature of a settlement is that it is a compromise, and a compromise isn’t the same thing as lying down and playing dead.”

Certainly, some legal observers blame the Great Recession in part on lack of regulation of the derivatives market and over-the-counter swaps. There have been calls for increased regulation, including global coordination. Some observers believe that by reforming the market, the government can reduce the likelihood of another similar financial debacle.

With the aim of preventing further crises, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Under the act, the Financial Stability Oversight Council monitors the financial stability of major entities, such as investment banks, whose collapse could seriously hurt the U.S. economy. The act provides for orderly liquidations or restructurings if these entities flounder. Also under the act, the Consumer Financial Protection Bureau is tasked with preventing predatory mortgage lending.

In part, the Dodd–Frank Act aims to improve accountability and transparency in the financial system, and particularly with transactions based upon derivatives. The act’s Volcker rule regulates the use of derivatives in an attempt to reduce risk-taking.

Manns says “nobody really knows if the reforms will work,” and he emphasizes that the government has always had trouble keeping regulations current and, therefore, effective in the face of financial innovation. “You can’t know how effective sea walls are until the next tsunami hits,” he adds.

To some critics, new regulations are practically irrelevant. The crisis occurred not because of the amount of power given to regulators, but because of how little regulators did with their existing power.

“It was not a problem of lack of regulatory power, just a problem of lack of regulatory judgment,” says Kitch. “The government is trying to sell the notion that they didn’t have the power to regulate this and that reform is needed. But they had plenty of regulatory power.”

Kitch says financial regulators—both bank regulators and the SEC—could have challenged the valuations of the mortgage securitizations assets that banks and other financial institutions were using. “But they did nothing until it was too late,” he points out.

Greenberger says increased regulation doesn’t deter fraudulent and reckless behavior; prosecutions do. “If you really want to wring fraud out of the system, you have to have full-throated investigations, coordination with states, and then indictments,” he says. “But we aren’t seeing that here.”

Lessons From the Past
Financial failures and subsequent investigations are nothing new. The United States has seen its share of dramatic financial mishaps, including the Great Depression and the energy crisis of the early 2000s.

In the aftermath of the 1929 stock market crash, the Senate Committee on Banking and Currency held a public inquiry into what happened. However, at that time, the Justice Department was not set up for extensive white-collar crime investigations as it is today. These days the agency is generally known for having an active and aggressive white-collar crime section.

In the 1980s, Justice Department prosecutors pursued numerous individuals involved in the savings-and-loan crisis, from low-level employees to Charles Keating, former head of Lincoln Savings and Loan.

In 2001 energy company Enron Corporation went bankrupt, revealing a pattern of fraudulent corporate behavior. In the wake of the scandal, the Justice Department formed a task force that investigated, indicted, and prosecuted former Enron officials and Enron’s auditor Arthur Andersen LLP.

But the Justice Department’s pursuit of Andersen was not well received in the end by the public or the courts, according to some experts. In 2002 the accounting firm was convicted of obstruction of justice relating to the investigation into Enron’s accounting activities. But in 2005 the U.S. Supreme Court unanimously overturned Andersen’s conviction, saying the jury instructions were fatally flawed.[1] In the meantime, the department’s pursuit of Andersen put the company out of business. Some critics said the individuals involved, not the company as a whole, should have been targeted.

In a more recent case, prosecutors pursued financier Bernie Madoff for his massive Ponzi scheme. In 2009 Madoff pleaded guilty to 11 charges, including fraud, perjury, and money laundering, and admitted that he defrauded thousands of investors of billions of dollars. Madoff was sentenced to 150 years in jail, the maximum sentence for his crimes.

Thanks to the Justice Department’s high-profile prosecutions, the public has become accustomed to public court proceedings against high-level corporate executives, says Frenkel of Shulman Rogers.

“It may be that the public has become so jaded by the perp walks of the Enron and Madoff eras that there is an expectation that every high-profile investigation should include senior official prosecutions,” Frenkel says. “It doesn’t work that way. There needs to be evidence. Prosecutors often have to make what is an unpopular decision that there is no criminal case to bring.”

For years, federal prosecutors have investigated the role of JPMorgan and other banks without resulting in any major “perp walks” or much-touted convictions. Federal investigators also are reportedly probing whether, even in the years following the financial meltdown, banks deliberately mispriced mortgage-backed securities. The probe is focused in part on whether traders crossed the line from aggressive sales tactics to fraud.

Indeed, the Justice Department tried, but failed, to hold some individuals accountable for their actions relating to toxic mortgages with overstated values. Months before Lehman Brothers crashed, federal prosecutors charged Ralph Cioffi and Matthew Tannin, two former Bear Stearns hedge fund managers, with falsely inflating the value of their portfolios despite knowing the shakiness of the mortgage-backed assets in the funds. In 2009 a jury in U.S. District Court in Brooklyn, New York, acquitted the men on all charges. Afterwards, one juror called Cioffi and Tannin “scapegoats for Wall Street.”

Langevoort says jurors are sensitive to the concept of blaming a few individuals for a more complicated, widespread series of problems.

“You can go back in time and see that there was broad responsibility. You can just as easily tell a story about the foolishness of the buy side as you can about the greediness of the sell side,” says Langevoort. “And that makes it hard to send one or two people to the gallows, saying, ‘This is all your fault.’”

In another investigation, federal prosecutors had been looking into the extent to which Angelo Mozilo, former chair of Countrywide Financial Corp., knew of the toxicity of the subprime mortgages his company sold.

In 2010 Mozilo settled insider-trading allegations with the SEC by agreeing to pay a total of $67.5 million. Of that amount, Mozilo agreed to pay $22.5 million out of his own pocket. Bank of America Corp., which bought Countrywide in 2008, pays the remainder due to a Countrywide indemnification agreement with Mozilo.

Countrywide was known for making or buying mortgages, and then selling them quickly to Fannie Mae or elsewhere. Federal prosecutors in Los Angeles initially pushed for a criminal investigation of Mozilo. They collected evidence of his level of knowledge, including e-mails in which he described the mortgage-backed loans as “toxic” and “poison.” Nevertheless, he allowed Countrywide to continue selling them.

“In all my years in the business, I have never seen a more toxic product,” he wrote in one e-mail. “With real estate values coming down . . . the product will become increasingly worse.”

But in 2011 federal prosecutors dropped the investigation. The Los Angeles Times and other newspapers cited sources as saying anonymously that there were concerns that were they to file a case against Mozilo, they were at risk of losing.

“Any prosecutor has to take a deep breath, then dig into each individual case and ask whether the level of knowledge, the level of complicity, was such that this person should be singled out and sent to jail,” says Langevoort. “The closer you look at these cases, however, the more you find that they are much more gray than they first appear.”

Too Big to Jail?
The Justice Department has a fairly heavy arsenal of potential crimes at its disposal to charge wrongdoers, including fraud and, specifically, the relatively easy-to-prove mail or wire fraud under the Racketeer Influenced and Corrupt Organizations Act.

But as anyone who followed the Enron investigation recalls, a probe into complicated financial crimes can take months, even years, of work. While investigators may dig up evidence of fraud or recklessness from low-level employees, prosecutors generally attempt to use that evidence to put pressure on employees to flip and implicate higher-level officials.

Critics have expressed concern that the Justice Department’s investigations are stalled due to apprehension that pursuing criminal charges against those involved in the toxic mortgage-backed securities market could hurt the overall economy. Since the investigations began, federal regulators have reportedly discussed whether certain banks are “too big to jail,” meaning that criminal charges against the banks themselves could lead them to fail. If the banks fail, their collapse would likely hurt the overall economy.
Federal regulators have said that under U.S. law they are required to pull licenses of banks convicted of criminal charges.

Last year, U.S. Attorney General Eric Holder told the Senate Judiciary Committee, “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.”

Separately, Raman, the former acting assistant attorney general for the Justice Department’s Criminal Division, testified before the House of Representatives in 2013 that the department’s United States Attorneys’ Manual “requires our prosecutors to consider a number of factors in determining how and whether to proceed.”

“There has been some discussion in recent months about one of those factors—the potential collateral consequences of charging a corporate entity,” said Raman during the hearing titled “Who Is Too Big to Fail: Are Large Financial Institutions Immune From Federal Prosecution?”

“[T]he U.S. Attorney’s Manual requires federal prosecutors to consider the potentially adverse impact a prosecution may have on investors, pension holders, customers, employees, and the public, including on innocent people who had nothing to do with the criminal conduct.”

But Raman added that, “of course, we do not consider such factors in deciding whether or not to charge individual executives and employees.”

Indeed, Holder told MSNBC this past January, “There are no individuals who are in such high-level positions that they cannot be indicted, criminally investigated.” He also noted that there “are no institutions that are too big to indict.”

Critics say the federal government should pursue more aggressively individual wrongdoers, claiming that the Justice Department has, in recent years, showed a willingness to bypass criminal charges in favor of ensuring bank stability.

“Eric Holder’s legacy will be he did next to nothing to hold people accountable,” says Greenberger. “The bottom line is that they didn’t prosecute bank officials because they thought it would destabilize the economy.”

In a January editorial for The New York Review of Books, Judge Jed S. Rakoff of the U.S. District Court for the Southern District of New York blasted federal prosecutors for how they approached potential wrongdoing in the aftermath of the financial crisis.

“[F]rom a moral standpoint, punishing a company and its many innocent employees and shareholders for the crimes committed by some unprosecuted individuals seems contrary to elementary notions of moral responsibility,” Judge Rakoff wrote.

He noted that if the Great Recession was the product of intentional fraud, then “the failure to prosecute those responsible must be judged one of the more egregious failures of the criminal justice system in many years.” A five-year statute of limitations is approaching for certain potential charges, experts have said.

Rakoff, former chief of the securities fraud unit at the U.S. Attorney’s Office for the Southern District of New York, noted that “[t]o a federal judge, who takes an oath to apply the law equally to rich and to poor,” the excuse that some companies or individuals are “too big to jail” is “disturbing, frankly, in what it says about the department’s apparent disregard for equality under the law.”

Rakoff added that “[i]n fairness,” Holder was “referring to the prosecution of financial institutions, rather than their CEOs.” Still, he suggested that many U.S. Attorney’s Offices have little or no experience pursuing financial fraud cases against high-level executives, or the resources to go after them.

“I want to stress . . . that I do not claim that the financial crisis that is still causing so many of us much pain and despondency was the product, in whole or in part, of fraudulent misconduct,” Rakoff wrote. “But if it was—as various governmental authorities have asserted it was—then the failure of the government to bring to justice those responsible for such colossal fraud bespeaks weaknesses in our prosecutorial system that needs to be addressed.”

Another reason prosecutors could be hesitant to file charges against high-level corporate officials has to do with the difficulty of proving fraud cases under these circumstances. In particular, some legal experts say prosecutors would struggle to prove criminal intent. Many of the top executives, some experts claim, would likely have avoided leaving behind a trail of evidence leading to them.

On the other hand, prosecutors have evidence that certain individuals involved in the pooling of assets knew that they were overvaluing the mortgage assets and misleading regulators and investors. For example, former Countrywide chief executive Mozilo praised his mortgage company’s practices publicly, while privately he worried about the viability of particular mortgage loans his company garnered.

In addition, the doctrine of “willful blindness” or “conscious disregard” is well established in criminal law, as Judge Rakoff pointed out in his editorial. Rakoff noted that the U.S. Supreme Court in 2011 once again approved the doctrine so that defendants “cannot escape the reach of . . . statutes by deliberately shielding themselves from clear evidence of critical facts that are strongly suggested by the circumstances.”[2]

“A top-level banker, one might argue, confronted with growing evidence from his own and other banks that mortgage fraud was increasing, might have inquired why his bank’s mortgage-based securities continued to receive AAA ratings,” wrote Rakoff.
But Zuckerman Spaeder’s Goelman, a former assistant U.S. attorney in the Southern District of New York, says “it is unfair to point a finger at prosecutors and accuse them of going easy on Wall Street.”

“Any prosecutor would want to be able to convict the CEO of a major investment bank,” he says. “That would be a great thing for any prosecutor’s career. The absence of charges means that prosecutors haven’t found the evidence to bring that kind of case.”

Freelancer writer Anna Stolley Persky wrote about temporary contract attorneys in the January 2014 issue of the magazine.

[1] Arthur Andersen LLP v. United States, 544 U.S. 696 (2005).
[2] Global-Tech Appliances, Inc. v. SEB S.A., 131 S. Ct 2060 (2011).