The PSI started investigating Wall Street’s part in the financial crisis in November 2008, and its final report, published this April, is bipartisan. It does not explicitly recommend specific criminal charges, but simply lays out the facts. From our conversations with federal prosecutors, we believe they have been scouring the PSI report to find adequate evidence to support a criminal case. The PSI report singles out many credit-rating and regulatory agencies for criticism; but we are going to focus on one that we believe clearly illustrates substantial evidence of criminal fraud and is also at the core of the crisis—the sales of complex mortgage securities to major investors.
The deal in question involves a $1.1 billion offering called Gemstone 7, assem- bled by the large German bank Deutsche Bank. It was sold over seven months between October 2006 and March 2007, at a time when subprime defaults were accelerating and mortgage-based securities were beginning to fall in value. Gemstone 7 was a collateralized debt obligation, or CDO, essentially a pool of subprime mortgage securities, some portions of which are given high ratings by ratings agencies because they are first in line to receive interest payments from the mortgage holders.
The Gemstone 7 pool of mortgage bonds was particularly risky. Numerous e-mails uncovered by the PSI show that Deutsche Bank’s traders knew full well the risks of these securities. Almost a third of Gemstone 7’s securities were subprime mortgages issued by Long Beach, Fremont, and New Century, three notoriously low-quality lenders, according to PSI analyses. According to the Senate report, Deutsche Bank’s own employees used words like “crap” and “pigs” to describe these mortgages, and the bank’s traders even bet against some of these securities themselves.
Deutsche Bank’s salespeople should have informed their clients directly about the risky nature of Gemstone 7’s securities. Instead, they sent clients sales documents that touted the deal, which included only boilerplate warnings, and then aggressively pushed their clients to buy the securities. The evidence suggests they knew what they were doing, and furthermore, they knew the relevant markets in these securities were starting to fall. One salesman’s e-mail stated, “We need to sell it now while we still can.” Another advised, “Keep your fingers crossed but I think we will price this just before the market falls off a cliff.” As the securities started to decline in value, investors were even given estimates of the value that were higher than Deutsche Bank itself made. One investor interviewed by the PSI said that from what he had been told, he believed the securities were good values. Moreover, a major CDO trader at Deutsche Bank sold an enormous volume of similar securities, earning nearly $6 billion for the firm overall.
Other evidence suggests that various people knew that the deal’s triple-A credit ratings were dubious. The PSI report describes how both S&P and Moody’s had given low, subinvestment-grade ratings to one third of the assets in Gemstone 7. Yet both S&P and Moody’s gave triple-A ratings to 73 percent of the securities in the Gemstone 7 offering, and high “investment grade” ratings to nearly all of the securities. Today, the $700 million of investments in Gemstone 7 that Deutsche Bank sold to clients are worthless. Deutsche Bank itself lost a large part of the remaining $400 million of Gemstone 7 that it couldn’t unload on investors, though it tried hard to do so.
Gemstone 7 is a nasty story of deception at the fourth-largest issuer of CDOs in the US. Deutsche Bank was an aggressive dealer in CDOs in the period when the market was beginning to crack. It created fifteen from December 2006 through December 2007, amounting to $11.5 billion. The evidence implicates many of Deutsche Bank’s employees, and is far more convincing than the evidence in many of the various SEC cases.
Yet no legal case has yet been made against the bank. Prosecutors expect a defense from Deutsche Bank to say that it satisfied the law by giving its clients general disclaimers about risks and that the large pension and other institutional investors that bought the securities were highly sophisticated and should have known about the risks even if they weren’t disclosed in detail. The defense might also claim that it was the ratings agencies, not Deutsche Bank, that were to blame. Finally, a jury may not be able to readily understand the complex issues.
But it seems clear to us from the documents we have read that a criminal case should be made based on Gemstone. The evidence of the duplicity of employees is substantial; indeed, it is more substantial than in other cases we have seen. And if there were a guilty verdict, it would establish precedents that would make other prosecutions workable. Then—and perhaps only then—would a strong deterrence against such activities be created. If prosecutors are paralyzed by fear of losses and the complexity of these cases, justice may never be done.
William Cohan, a journalist and ex-banker, begins and ends Money and Power, his comprehensive, though sometimes sprawling, history of Goldman Sachs by laying out the PSI’s evidence related to Goldman. Although Cohan didn’t have the benefit of the PSI’s report (it was published one day after the publication date of his book), he was able to draw from documents made public by the PSI in 2010.
One of the cases Cohan discusses is familiar: the SEC’s civil case already mentioned against Goldman and one of its vice-presidents, Fabrice Tourre, who remains a defendant. In that deal, generally known as the Abacus transaction, Goldman was accused of selling a CDO backed by securities that were chosen by a hedge fund eager to see them decline. Goldman did not inform investors about the hedge fund’s involvement and was even selling some of the same kinds of securities while it urged clients to buy them.
Several e-mails implicated Tourre, but he was not criminally charged, presumably again because prosecutors feared bringing a case with complex facts and broad disclaimers that required a high standard of proof; so Goldman paid a fine that by historical standards was high but was small compared to its own earnings. But what is most interesting about Goldman’s response to the Abacus settlement is the bank’s publication of a sixty-three-page report describing its view of the modern investing world.
Goldman’s report concludes that it should disclose conflicts of interest when it acts as an adviser or fiduciary to its clients. That might seem like an admission of guilt regarding Abacus. But Goldman insists that in the Abacus and similar cases it was not acting as a fiduciary—that is to say, an adviser with responsibilities to point out risks. Rather, Goldman says, it was merely a “market maker.” The law is more stringent about the disclosure requirements of an underwriter or a broker than a market maker.
A market maker trades, say, IBM stock for its clients. It may even build investments in the stock to sell, if possible, at a profit—or it may sell the stock short (that is, without owning it), because it believes it will fall in price. This is a core business for most securities firms for thousands of stocks, bonds, currencies, commodities, and other securities. Until recent regulatory legislation, market makers were also allowed to engage in so-called proprietary trading—speculation on securities they thought were overvalued or undervalued. Restrictions on that practice, known as the Volcker Rule, named after the former Federal Reserve chairman Paul Volcker, who recommended it, are still being worked out—and may well be seriously watered down under the influence of lobbyists.
But when making a market in a particular security, Goldman argues, the firm is not obligated to provide advice or disclose conflicts of interest, even if, say, it believes IBM is overpriced. Instead, the rule is that the buyer must beware.
Still, selling complex CDOs is not the equivalent to making a market in stocks or other widely traded securities. The shares of IBM and countless other stocks, Treasury bonds, and currencies are far more simple to understand and often are subject to independent research analyses. Moreover, Goldman has no involvement in IBM’s business decisions, for example. The CDOs at hand, however, were created by Goldman bankers with help from a hedge fund, and the bankers knew much more than their clients did about how risky they were. Moreover, the bankers actively sold them to investors; they did not essentially accommodate investor needs, as they might with IBM shares. The line between these activities can be fuzzy but, in our view, to sell CDOs as Goldman did is not simply to make a market in them, and we believe prosecutors should test this view in court. They should argue that those who sell complex financial products—not only Goldman but all other banks such as Deutsche Bank—owe their clients further duties as if, as Goldman points out, they were advisers with fiduciary responsibilities.
Insider trading is the one Wall Street crime that prosecutors have treated the same way they treat street crime. Today’s bankers know they could face jail time for trading clients’ shares when they have nonpublic information about the company. As a result, federal prosecutors bring about fifty insider trading cases per year, and both Wall Street and investors benefit from the confidence in US capital markets that this enforcement creates.
A strong argument can be made that the US should treat more financial activities as it does insider trading, making clear that investment firms have broad responsibilities that go well beyond mere market-making. It would require courageous prosecutors to advocate such an approach today, and any defendant would strongly protest the approach as making conduct criminal after the fact. But there are plenty of precedents and arguments for judges to find that bankers have broader responsibilities.
In the case of Gemstone, prosecutors could charge salespeople with committing fraud because they knew the securities they were selling carried risks that their investors did not understand and could not have understood from the limited information provided them. In other words, they would have to take responsibility to some degree for the misguided decisions of investors to whom they failed to give critical information. Prosecutors could also ask a court to adopt a standard by which Wall Street companies should have known the crucial risks even if they didn’t have full knowledge of them. The SEC has recently used this standard in a civil case, charging that an employee of JPMorgan should have known that investors in one of the bank’s CDOs were misled. This approach would make egregious “negligence” criminal in financial cases as it is, for example, in vehicular homicide. Regardless of what happens in this case, Congress could also expressly pass legislation along these lines, or even redefine fraud to apply if bankers knew that securities were designed to circumvent regulations or hide risks.