John Damgard bit his tongue as William Black addressed delegates at the annual Burgenstock Meeting in Interlaken, Switzerland.
It was early September, and Black, a professor of law and economics at the University of Missouri, was giving his take on the financial crisis that surfaced in 2008. He’d earned his cred as litigation director for the Federal Home Loan Bank Board (FHLBB) and deputy director of the Federal Savings and Loan Insurance Corporation (FSLIC) in the 1980s, and has been researching white-collar crime ever since.
Damgard, a consummate diplomat, had run the Futures Industry Association from its inception in 1982 until last year, when he passed the baton to former Commodity Futures Trading Commission (CFTC) Acting Chairman Walt Lukken. Normally ebullient, Damgard fumed as he watched Black blame the housing bubble on the twin cultures of corruption (among real-estate lenders) and trust (on the part of regulators).
When Black finished, Damgard strode to the dais and towered over him, waving his fist in the air as he turned to face the room.
“You don’t have to listen to this,” he told the audience. “More than 99% of the people who work in our industry are fine, upstanding and good people!”
The housing bubble, he said, wasn’t caused by a culture of corruption but by misguided government policies.
“It happened because do-gooders like Chris Dodd and Barney Frank believed that it was every American’s God-given right to have a house,” he said. “They provided government guarantees that distorted the market, and that’s where things went wrong.”
The raucous and wide-ranging debate — which we're told will be available online soon — veered from global rules of corporate governance to the vagaries of customer segregated funds, and from the philosophy of Adam Smith to the founding of Apple Computers. It echoed both the narrow debate that has engulfed the futures industry since MF Global and Peregrine Financial Group (PFG) violated the sanctity of customer segregated funds, and the larger debate that has inundated the entire financial services sector since that fateful day in 2008 when Alan Greenspan acknowledged that he may have overestimated the powers of benign self-interest.
Black drew parallels among the actions of Jon Corzine, Russell Wasendorf and Bernie Madoff, whose $65 billion Ponzi scheme remains the mother of all financial scandals (both in terms of size and regulatory failure).
“In each case, we had high-status individuals who, because of the status and respect they garner, ended up posing a much greater risk to the system,” Black said. “It’s very difficult to believe in the forefront of your mind as a regulator that the person sitting across from you in a nice suit is lying through his teeth to you and forging documents.”
If regulators aren’t given more support, he warned, the entire system will suffer. “Elite frauds are about the most aggressive assault on trust you can imagine,” he said. “They can shut down entire segments of the economy.”
Damgard agreed, but said the system basically was sound. “MF Global is a black eye, and a couple bad apples caused a lot of angst,” he said. “But the [regulatory] pendulum always swings too far.”
But how much regulation is too much — and how should it be targeted? To answer that, you have to look back at what has gone wrong over the past 25 years.
Damgard accuses Black of measuring regulation by its size and scope instead of its focus, and says we often end up with more regulation than we need because regulators fail to enforce the regulations that already exist. He concedes that over-the-counter (OTC) derivatives needed more regulation, but argues that the SEC should have caught Madoff with the regulations and resources at its disposal (see “Types of failures”).
Fixing systemic disruptions
Legislators in both the United States and Europe have vowed to implement new regulatory regimes that will reel in the OTC derivatives market and beef up customer protection (see “Regulators: No more Mr. Soft Touch,” Futures, July 2009).
By year-end, the European Commission is scheduled to finalize sweeping reforms to the Markets in Financial Instruments Directive (MiFID) and fully implement the European Market Infrastructure Regulation (EMIR). MiFID primarily deals with existing markets, while EMIR aims to pull standardized OTC derivatives into a central clearing regime and impose higher capital requirements on those that aren’t standardized. Together they do in Europe what the Dodd-Frank Wall Street Reform and Consumer Protection Act is mandated to do in the United States.
A pattern of regulatory failure?
Isaac le Maire earned a place in history as the first person to manipulate the stock market when he sold more shares in the Dutch East India Company than he actually owned. That was in 1609 — seven years after the Dutch invented the modern limited liability company — and le Maire wasn’t shorting shares for speculation but to try and kill the company. His action sparked the first regulatory response to modern manipulation: A ban on naked short-selling.
There have been plenty of abusive cycles since, but University of San Diego Professor Frank Partnoy says our current ills began in the late 1980s. He lays out his arguments in “Infectious Greed: How Deceit and Risk Corrupted the Financial Markets,” which identifies three drivers of financial irresponsibility that he says became particularly acute in the last 25 years.
First, he says, we saw the emergence of complex OTC derivatives. Unlike the other drivers, these are unique to our time, and they pushed risk underground to avoid regulation.
Second, we saw a growing separation of control and ownership — the “agency risk” of which Adam Smith warned.
Finally, we saw the euphoric deregulation of the 1990s — which echoed the pure-free-market fundamentalism of the 1890s.
In his narrative, these three developments led to financial irregularities that sunk non-finance companies such as WorldCom and Global Crossing as well as derivatives players like Enron — and led so many of us to be seduced by “soft-touch” regulatory approaches that permeated markets up until the 2008 disaster.
The implosion of PFG highlighted failures within the National Futures Association (NFA) that the NFA — to its credit — readily admits and seems intent on correcting (see “In PFG fraud, everyone loses — except the lawyers,” October 2012); and the MF Global debacle highlighted failures at the CFTC and within the global bankruptcy arena.
But the Securities and Exchange Commission (SEC) topped them both when it didn’t just fail to notice Madoff, but seemed actively intent on ignoring him after Harry Markopolos blew the whistle in 1999… and again in 2001… and again and again… as recounted in “No One Would Listen: A True Financial Thriller.”
The most alarming, but least surprising, thing about his story is that everyone on Wall Street who knew anything about markets knew something was fishy with Madoff’s 1% a month returns, but few cared because they figured he was “only” front-running — which amounts to illegally skimming from your customers. Everyone did it, Markopolos says, but no one cared, and the SEC remained blind despite the fact that Madoff would have needed to control multiples of the open interest on the Chicago Board Options Exchange (CBOE) to carry out the strategy he claimed he was carrying out.
Compare that to the CFTC — which, even in Markopolos’s book, follows up on tips and nails the bad guys.
Pigs get slaughtered?
It’s an old edict of trading that bears win, bulls win and pigs get slaughtered; but that hasn’t been the case in the past decade — when pigs arguably have been protected. Former Federal Deposit Insurance Corporation Chair Sheila Bair related an interesting anecdote from the penultimate Troubled Asset Relief Program (TARP) meeting during the 2008 credit crisis in a recent interview. All the pertinent regulators and bank executives were in attendance, and the first question asked during the bailout negotiations was from Merrill Lynch CEO John Thain. But it wasn’t about justice. It was about executive compensation.
They were discussing U.S. taxpayers bailing out the entire U.S. banking industry to the tune of hundreds of billions of dollars, and Thain wanted to make sure he still was getting his.
Bair referred to Thain derisively as one of the “masters of the universe” who Thomas Wolfe lampooned in his 1987 novel “Bonfire of the Vanities” — a book that ushered out the era of junk bonds and ushered in the current era, when fines levied against banks that get caught kicking around markets often pale in comparison to both the size of their systemic disruption and the money they siphon out. Barclays, for example, paid a grand total of $450 million to U.S. and U.K. regulators for fixing rates in the $10 trillion Libor market — and no one has faced criminal charges despite the fact that Section 2 of the U.K.’s Fraud Act 2006 says a banker or trader has committed fraud if he “(a) dishonestly makes a false representation, and (b)intends, by making the representation — (i)to make a gain for himself or another, or (ii)to cause loss to another or to expose another to a risk of loss.”
In July, New York Times reporter James Stewart identified a long litany of instances when UBS had negotiated immunity from prosecution for acts that would have landed lesser mortals in prison — including participation in the Libor scandal. In “For UBS, a record of averting prosecution,” he also makes a strong case for ignoring that immunity.
“A corporation, like a natural person, is expected to learn from its mistakes,” he writes, citing the Justice Department itself. “A history of similar misconduct may be probative of a corporate culture that encouraged, or at least condoned, such misdeeds, regardless of any compliance programs. Criminal prosecution of a corporation may be appropriate particularly where the corporation previously had been subject to noncriminal guidance, warnings or sanctions.”
Then there’s HSBC, which apologized for laundering money on behalf of “drug kingpins and rogue nations.” The list goes on and on.
In September, Martin Wheatley published the 92-page “Review of Libor: Final Report” that details sweeping reforms to Libor distilled from months of industry consultation. In the report, Wheatley, who will run the new Financial Conduct Authority (FCA) that takes over market-monitoring from the Financial Services Authority (FSA), says there may be a criminal case, but that the Fraud Act isn’t part of the FSA’s or FCA’s jurisdiction. The Serious Fraud Office says it’s looking into the matter, but also isn’t sure if it can prosecute.
And it’s that kind of legal slipperiness that has stymied regulators on both sides of the Atlantic for more than a decade. More than 20 banks participated in the Libor scandal, but Barclays is the only one to pay a penalty to date.
Are we all just numb?
There seems to be a lack of outrage over the Libor scandal considering its scope, but perhaps there is an exhaustion or frustration factor with what appears to be a lack of accountability. While it is hard to keep a score card, the credit crisis of 2008 that resulted in the failure of Lehman and multiple bailouts, including TARP, that led to the great recession is ground zero.
There have been no criminal charges filed and the civil cases have left many dissatisfied. Case in point, Judge Jed Rakoff vs. the SEC. In what looked to be a routine filing last November, the SEC charged Citigroup with negligence in selling a $1 billion investment product tied to housing in 2007 without telling investors it was betting against it. Citigroup agreed to pay $285 million and be on its way, “without admitting or denying wrongdoing.”
What wasn’t routine is that it would be sent to Judge Jed Rakoff of the Federal District Court in Manhattan for approval. Rakoff had disallowed an SEC settlement with Bank of America in 2009 on similar grounds. He rejected this one noting that if the charge were true, then the penalty was not strong enough. In ordering the case go to trial, Rakoff wrote, “The SEC, of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances.”
The SEC appealed the ruling and Rakoff later issued a supplemental order claiming the SEC filed a “materially misleading” request seeking an emergency halt to further proceedings.
The largest settlement related to the various questionable subprime related products created and marketed by investment banks was Goldman Sachs’ $550 million SEC fine two years ago after getting caught colluding with Paulson & Co. to create and market collateralized debt obligations so that Paulson could take the other side. In fact, this settlement preceded the similar Citi case, adding to Rakoff’s puzzlement.
The settlements are indeed large, but they close the window to criminal prosecution and prevent us from clearly determining guilt or even wrongdoing — and do little to deter future bad actors. Click here for a complete list of enforcement cases.
The SEC lists 115 entities and individuals charged with misconduct related to the 2008 financial crisis, which resulted in more than $1.4 billion in penalties ordered or agreed to and $2.2 billion in total monetary relief. Perhaps if firms' existences were threatened by recidivist violations and leaders were held more accountable, this list would be shorter.
Types of failures
Regulatory failures broadly fall into three categories: Rogue traders, systemic disruptions and outright acts of thievery.
Rogues often are traders who just got lost in the game and took on more risk than they were authorized to — sometimes to earn a bonus, other times to feed their egos and often because they believe they have the tacit approval of management, usually with justification (after all, Jon Corzine actually was management). The victims usually are the company and its creditors.
When other market participants or the market itself are the victims, then it’s a systemic failure — and most of those have happened because someone ran amok in the multi-trillion-dollar market for unregulated derivatives. Here, even industry booster John Damgard acknowledges that some degree of regulatory change was needed, but he doesn’t go as far as Alan Greenspan did when he told the House Committee on Oversight and Government Reform, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”
Some systemic disruptions are intentional — like those that happen when someone tries to corner a market — but most of them aren’t. Neither Long Term Capital Management nor AIG, for example, wanted to disrupt markets — although William Black argues that bonus-blind individuals across the real estate lending apparatus knowingly passed bad loans into the system. This, he long has argued, is organized fraud on a massive scale and deserves to be prosecuted as such.
“In the Savings and Loans crisis, which was 1/70th the size of this crisis, our agency made [more than] 10,000 criminal referrals that resulted in felony convictions for more than 1,000 executives,” says former prosecutor Black. “In the housing crisis, the number of referrals is zero.”
He lauds the Justice Department for suing J.P. Morgan Securities for misconduct in the packaging and sale of mortgage securities during the housing boom, but that suit is civil — not criminal. The recent wave of banking scandals — from housing to Libor — aren’t just inadvertent disruptions, he says. They’re criminal acts.
Black argues that the criminal justice system has been on the same slippery moral slope that ensnared Charles Ponzi and Nick Leeson. Neither set out to break the law. Ponzi started out with a half-baked plan to arbitrage postage stamps issued in different currencies, while Leeson thought he could trade a colleague out of an error. After a while, they lost sight of the boundary between right and wrong.
In his book “Infectious Greed: How Deceit and Risk Corrupted the Financial Markets,” University of San Diego Professor Frank Partnoy identifies Andy Krieger as “patient zero” of our current epidemic. Nearly forgotten today, Krieger became an early success in options under Charlie Sanford at Bankers Trust in the 1980s. As Krieger’s successes grew, so did his power within the company — which he abruptly left after the company reneged on the bonus he felt he was due.
Only then did Banker’s Trust realize it had miscalculated Krieger’s winnings, and was forced to reduce them by $80 million. Rather than come clean fully, it pressured accountants at Arthur Young to reduce its obligation to pay employees’ future bonuses by exactly that amount — and the twin practices of free-wheeling trader and accounting shenanigans were enabled.
Partnoy takes us step-by-step down the slippery slope of deregulation as more and more companies enter swaps not to offset risk, but to manipulate their accounting results and hide from regulators.
CRIME: Concealed from investors risks, terms, and improper pricing in CDOs and other complex structured products…
Citigroup - Misleading investors about a $1 billion CDO tied to the housing market in which Citigroup bet against investors as the housing market showed signs of distress. $285 million settlement. (10/11)
Goldman Sachs - Defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter. $550 million settlement. (7/10)
ICP Asset Management - Fraudulently managing investment products tied to the mortgage markets as they came under pressure. Unspecified settlement. (9/12)
J.P. Morgan Securities - Misleading investors in a complex mortgage securities transaction just as the housing market was starting to plummet. $153.6 million settlement. (6/11)
Mizuho Securities USA - Misleading investors in a CDO by using “dummy assets” to inflate the deal’s credit ratings while the housing market was showing signs of severe stress. $127.5 million settlement. (7/12)
Stifel, Nicolaus & Co., RBC Capital Markets - Defrauding five Wisconsin school districts by selling them unsuitably risky and complex investments. $30.4 million settlement. (9/11)
Wachovia Capital Markets - Misconduct in the sale of two CDOs tied to the performance of residential mortgage-backed securities as the housing market was beginning to show signs of distress. $11 million settlement. (4/11)
Wells Fargo - Selling investments tied to mortgage-backed securities without fully understanding their complexity or disclosing the risks to investors. $6.5 million settlement. (8/12)
CRIME: Made misleading disclosures to investors about mortgage-related risks and exposure…
American Home Mortgage - SEC charged executives with accounting fraud and misleading investors about the company's deteriorating financial condition as the subprime crisis emerged. Former CEO settled charges by paying $2.45 million and agreeing to five-year officer and director bar. (4/28/09)
BankAtlantic - SEC charged the holding company for one of Florida's largest banks and CEO Alan Levan with misleading investors about growing problems in one of its significant loan portfolios early in the financial crisis. (1/18/12)
Citigroup - SEC charged the company and two executives with misleading investors about exposure to subprime mortgage assets. Citigroup paid $75 million penalty to settle charges, and the executives also paid penalties. (7/29/10)
Countrywide - SEC charged CEO Angelo Mozilo and two other executives with deliberately misleading investors about significant credit risks taken in efforts to build and maintain the company's market share. Mozilo also charged with insider trading. (6/4/2009)
Mozilo Settled Charges - Agreed to record $22.5 million penalty and permanent officer and director bar. (10/15/10)
Franklin Bank - SEC charged two top executives with securities fraud for misleading investors about increasing delinquencies in its single-family mortgage and residential construction loan portfolios at the height of the financial crisis. (4/5/12)
Fannie Mae and Freddie Mac - SEC charged six former top executives of Fannie Mae and Freddie Mac with securities fraud for misleading investors about the extent of each company's holdings of higher-risk mortgage loans, including subprime loans. (12/16/11)
IndyMac Bancorp - SEC charged three executives with misleading investors about the mortgage lender's deteriorating financial condition. (2/11/11)
CEO Settles Case - IndyMac's former CEO and chairman of the board Michael Perry agreed to pay an $80,000 penalty. (9/28/12)
New Century - SEC charged three executives with misleading investors as the lender's subprime mortgage business was collapsing. (12/7/09)
Executives Settled Charges - Paid more than $1.5 million and each agreed to five-year officer and director bars. (7/30/10)
Option One Mortgage Corp. - SEC charged the H&R Block subsidiary with misleading investors in several offerings of subprime residential mortgage-backed securities by failing to disclose that its financial condition was significantly deteriorating. The firm agreed to pay $28.2 million to settle the charges. (4/24/12)
Thornburg executives - SEC charged three executives at formerly one of the nation's largest mortgage companies with hiding the company's deteriorating financial condition at the onset of the financial crisis. (3/13/12)
TierOne Bank executives - SEC charged three former bank executives in Nebraska for participating in a scheme to understate millions of dollars in losses and mislead investors and federal regulators at the height of the financial crisis. Two executives settled the charges by paying penalties and agreeing to officer-and-director bars. (9/25/12)
CRIME: Concealed the extent of risky mortgage-related and other investments in mutual funds and other financial products…
Bear Stearns - SEC charged two former Bear Stearns Asset Management portfolio managers for fraudulently misleading investors about the financial state of the firm's two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse of the funds in June 2007. (6/19/08)
Cioffi and Tannin Settled Charges - Agree to pay more than $1 million and accept industry bars. (6/18/12)
Charles Schwab - SEC charged entities and executives with making misleading statements to investors in marketing a mutual fund heavily invested in mortgage-backed and other risky securities. The Schwab entities paid more than $118 million to settle charges. (1/11/11)
Evergreen - SEC charged the firm with overstating the value of a mutual fund invested primarily in mortgage-backed securities and only selectively telling shareholders about the fund's valuation problems. Firm settled charges by paying more than $40 million, most of which was returned to harmed investors. (6/8/09)
Morgan Keegan - SEC charged the firm and two employees with fraudulently overstating the value of securities backed by subprime mortgages (4/7/10)
Morgan Keegan Settled Charges - Firm agreed to pay $100 million to the SEC and the two employees also agreed to pay penalties, including one who agreed to be barred from the securities industry. (6/22/11)
OppenheimerFunds - SEC charged the investment management company and its sales distribution arm for misleading statements about two of its mutual funds that had substantial exposure to commercial mortgage-backed securities during the midst of the credit crisis in late 2008. (6/6/12)
Reserve Fund - SEC charged several entities and individuals who operated the Reserve Primary Fund for failing to provide key material facts to investors and trustees about the fund's vulnerability as Lehman Brothers sought bankruptcy protection. (5/5/09)
State Street - SEC charged the firm with misleading investors about exposure to subprime investments while selectively disclosing more complete information to specific investors. State Street agreed to repay investors more than $300 million to settle the charges. (2/4/10)
Two Former State Street Employees Charged - Accused of misleading investors about exposure to subprime investments. (9/30/10)
TD Ameritrade - SEC charged the firm with failing to supervise representatives who mischaracterized the Reserve Fund as safe as cash and failed to disclose risks when offering the investment to customers. Firm settled charges by agreeing to repay $10 million to certain fund investors. (2/3/11)
Bank of America - SEC charged the company with misleading investors about billions of dollars in bonuses being paid to Merrill Lynch executives at the time of its acquisition of the firm, and failing to disclose extraordinary losses that Merrill sustained. Bank of America paid $150 million to settle charges. (2/4/10)
Brooke Corporation - SEC charged six executives for misleading investors about the firm's deteriorating financial condition and for engaging in various fraudulent schemes designed to conceal the firm's rapidly deteriorating loan portfolio. Five executives agreed to settlements including financial penalties and officer and director bars. (5/4/11)
Former CEO Settled Charges - The sixth executive agreed to an officer and director bar and financial penalty. (9/8/11)
Brookstreet - SEC charged the firm and its CEO with defrauding customers in its sales of risky mortgage-backed securities. (12/8/09)
Judge Orders Brookstreet CEO to Pay $10 Million Penalty - Stanley Brooks and Brookstreet Securities ordered to pay $10,010,000 penalty and $110,713.31 in disgorgement and prejudgment interest. (3/2/12)
Brookstreet Brokers Charged - SEC charged 10 Brookstreet brokers with making misrepresentations to investors in sale of risky CMOs. (5/28/09)
Colonial Bank and Taylor, Bean & Whitaker (TBW) - SEC charged executives at the bank and the major mortgage lender for orchestrating $1.5 billion scheme with fabricated or impaired mortgage loans and securities, and attempting to scam the TARP program.
Lee Farkas, Chairman of TBW (6/16/10)
Desiree Brown, Treasurer of TBW (2/24/11)
Catherine Kissick, Vice President at Colonial Bank (3/2/11)
Teresa Kelly, Supervisor at Colonial Bank (3/16/11)
Paul Allen, CEO of TBW (6/17/11)
Credit Suisse Group - SEC charged four former veteran investment bankers and traders for their roles in fraudulently overstating subprime bond prices in a complex scheme driven in part by their desire for lavish year-end bonuses. (2/1/12)
UCBH Holdings Inc. - SEC charged former bank executives with misleading investors about mounting loan losses at San Francisco-based United Commercial Bank and its public holding company during the height of the financial crisis. (10/11/11)
SEC charged former bank executive with misleading the bank's independent auditors regarding risks the bank faced on certain outstanding loans. (3/27/12)