The New York Review of Books

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Lloyd Blankfein, chairman and CEO of Goldman Sachs, and Al Sharpton at the Cooper Union, where President Barack Obama was giving a speech on financial regulation, New York City, April 22, 2010

More than three years have passed since the old-line investment bank Lehman Brothers stunned the financial markets by filing for bankruptcy. Several federal government programs have since tried to rescue the financial system: the $700 billion Troubled Asset Relief Program, the Federal Reserve’s aggressive expansion of credit, and President Obama’s additional $800 billion stimulus in 2009. But it is now apparent that these programs were not sufficient to create the conditions for a full economic recovery. Today, the unemployment rate remains above 9 percent, and the annual rate of economic growth has slipped to roughly 1 percent during the last six months. New crises afflict world markets while the American economy may again slide into recession after only a tepid recovery from the worst recession since the Great Depression.

In our article in the last issue,¹ we showed that, contrary to the claims of some analysts, the federally regulated mortgage agencies, Fannie Mae and Freddie Mac, were not central causes of the crisis. Rather, private financial firms on Wall Street and around the country unambiguously and overwhelmingly created the conditions that led to catastrophe. The risk of losses from the loans and mortgages these firms routinely bought and sold, particularly the subprime mortgages sold to low-income borrowers with poor credit, was significantly greater than regulators realized and was often hidden from investors. Wall Street bankers made personal fortunes all the while, in substantial part based on profits from selling the same subprime mortgages in repackaged securities to investors throughout the world.

Yet thus far, federal agencies have launched few serious lawsuits against the major financial firms that participated in the collapse, and not a single criminal charge has been filed against anyone at a major bank. The federal government has been far more active in rescuing bankers than prosecuting them.

In September 2011, the Securities and Exchange Commission asserted that overall it had charged seventy-three persons and entities with misconduct that led to or arose from the financial crisis, including misleading investors and concealing risks. But even the SEC’s highest- profile cases have let the defendants off lightly, and did not lead to criminal prosecutions. In 2010, Angelo Mozilo, the head of Countrywide Financial, the nation’s largest subprime mortgage underwriter, settled SEC charges that he misled mortgage buyers by paying a $22.5 million penalty and giving up $45 million of his gains. But Mozilo had made $129 million the year before the crisis began, and nearly another $300 million in the years before that. He did not have to admit to any guilt.

The biggest SEC settlement thus far, alleging that Goldman Sachs misled investors about a complex mortgage product—telling investors to buy what had been conceived by some as a losing proposition—was for $550 million, a record of which the SEC boasted. But Goldman Sachs earned nearly $8.5 billion in 2010, the year of the settlement. No high-level executives at Goldman were sued or fined, and only one junior banker at Goldman was charged with fraud, in a civil case. A similar suit against JPMorgan resulted in a $153.6 million fine, but no criminal charges.

Although both the SEC and the Financial Crisis Inquiry Commission, which investigated the financial crisis, have referred their own investigations to the Department of Justice, federal prosecutors have yet to bring a single case based on the private decisions that were at the core of the financial crisis. In fact, the Justice Department recently dropped the one broad criminal investigation it was undertaking against the executives who ran Washington Mutual, one of the nation’s largest and most aggressive mortgage originators. After hundreds of interviews, the US attorney concluded that the evidence “does not meet the exacting standards for criminal charges.” These standards require that evidence of guilt is “beyond a reasonable doubt.”

This August, at last, a federal regulator launched sweeping lawsuits alleging fraud by major participants in the mortgage crisis. The Federal Housing Finance Agency sued seventeen institutions, including major Wall Street and European banks, over nearly $200 billion of allegedly deceitful sales of mortgage securities to Fannie Mae and Freddie Mac, which it oversees. The banks will argue that Fannie and Freddie were sophisticated investors who could hardly be fooled, and it is unclear at this early stage how successful these suits will be.

Meanwhile, several state attorneys general are demanding a settlement for abuses by the businesses that administer mortgages and collect and distribute mortgage payments. Negotiations are under way for what may turn out to be moderate settlements, which would enable the defendants to avoid admitting guilt. But others, particularly Eric Schneiderman, the New York State attorney general, are more aggressively pursuing cases against Wall Street, including Goldman Sachs and Morgan Stanley, and they may yet bring criminal charges.

Successful prosecutions of individuals as well as their firms would surely have a deterrent effect on Wall Street’s deceptive activities; they often carry jail terms as well as financial penalties. Perhaps as important, the failure to bring strong criminal cases also makes it difficult for most Americans to understand how these crises occurred. Are they simply to conclude that Wall Street made well- meaning if very big errors of judgment, as bankers claim, that were rarely if ever illegal or even knowingly deceptive?

What is stopping prosecution? Apparently not public opinion. A Pew Research Opinion survey back in 2010 found that three quarters of Americans said that government policies helped banks and financial institutions while two thirds said the middle class and poor received little help. In mid-2011, half of those surveyed by Pew said that Wall Street hurts the economy more than it helps it.

Many argue that the reluctance of prosecutors derives from the power and importance of bankers, who remain significant political contributors and have built substantial lobbying operations. Only 5 percent of congressional bills designed to tighten financial regulations between 2000 and 2006 passed, while 16 percent of those that loosened such regulations were approved, according to a study by the International Monetary Fund.² The IMF economists found that a major reason was lobbying efforts. In 2009 and early 2010, financial firms spent $1.3 billion to lobby Congress during the passage of the Dodd-Frank Act. The financial reregulation legislation was weakened in such areas as derivatives trading and shareholder rights, and is being further watered down.

Others claim federal officials fear that punishing the banks too much will undermine the fragile economic recovery. As one former Fannie official, now a private financial consultant, recently told The New York Times, “I am afraid that we risk pushing these guys off of a cliff and we’re going to have to bail out the banks again.”

The responsibility for reluctance, however, also lies with the prosecutors and the law itself. A central problem is that proving financial fraud is much more difficult than proving most other crimes, and prosecutors are often unwilling to try it. Congress could fix this by amending federal fraud statutes to require, for example, that prosecutors merely prove that bankers should have known rather than actually did know they were deceiving their clients.

But even if Congress does not, it is not too late for bold federal prosecutors to try to bring a few successful cases. A handful of wins could create new precedents and common law that would set a higher and clearer standard for Wall Street, encourage more ethical practices, deter fraud—and arguably prevent future crises.

Basic financial fraud involves a financial firm’s relationship with its clients, investors, or trading partners. The securities laws of 1933 and 1934 require full and fair disclosure of material risks, those that reasonable investors would consider important. Moreover, even if the securities laws did not exist, the employees of the financial firms could be charged with violating a variety of other federal and state antifraud statutes, which prohibit making false statements in various circumstances. New York State passed an especially aggressive law in 1921, which gives prosecutors expansive powers to fight financial fraud. The common law, created through rulings over the years by judges, also prohibits fraud under many conditions.

Many people may understand that crimes typically have two central elements: actus reus, a guilty act, and mens rea, a guilty mind. To convict someone of criminal fraud under any of the laws we have mentioned, a prosecutor must prove both that the defendant misrepresented important facts to investors and also that he or she knew those facts were false. In other words, failure to disclose pertinent facts to investors out of sheer negligence can’t give rise to prosecutable fraud; there must be full knowledge that such essential information is not being disclosed.

But it is difficult to prove criminal knowledge. For one thing, the facts in financial cases are usually complicated. Not very many jurors, for example, would feel competent to assess the correlations in a mathematical model that misled investors about the riskiness of subprime mortgages.

Moreover, bankers almost always protect themselves from the possibility of lawsuits and prosecutions by warning their clients, often in pro forma statements, about hidden risks and conflicts of interest. And Wall Street banks typically require that any person or institution buying their products sign a statement saying that they are sophisticated enough to understand the risks of the investment. In the SEC’s cases against Goldman Sachs and JPMorgan, the clients who bought the complex investments backed by subprime loans received just such warnings, and some courts in the past have held that those warnings protect the banks from liability, even if they sold investments that were too risky, or unsuitable, for their clients.

For a prosecutor to prove criminal charges, there must be solid evidence “beyond a reasonable doubt” that bankers knew what they were telling clients was false. This standard is less rigorous in civil enforcement cases, but any such charge must still be proven, and government agencies often prefer to settle for a fine rather than risk losing in court. Bringing these cases is costly, and the Justice Department must use its resources carefully, as must the SEC and other federal agencies in making civil cases.

In fact, the one criminal case brought by federal prosecutors in 2008 against two hedge fund traders working at Bear Stearns resulted in a verdict of not guilty. Although some e-mails showed that the traders did not disclose important risks to their investors, other e-mails showed that they had hoped the markets would correct. The jury found these persuasive enough to determine that the traders were not completely deceitful.

But the Bear Stearns case did not go to the heart of the unethical behavior at the core of the financial crisis. The most useful compilation of new evidence about this behavior is Wall Street and the Financial Crisis, the recently published report by the United States Senate’s Permanent Subcommittee on Investigations. Created in the 1950s, the PSI is the most important investigative body of Congress and has pursued wrongdoing in organized crime, money laundering, child pornography, and the United Nations Oil-for-Food program. Typically, when the PSI gets involved, criminal convictions soon follow.