Too big to jail?

Why crime still pays
Willie Sutton, financial advisor

Willie Sutton was a famous bank robber who is alleged to have said, in response to a question asking why he robbed banks, “Because that’s where the money is.” When asked why he carried a gun, he said “You can’t rob a bank with just charm and personality”.

I was reminded of these two quotes when I read that the Department of Justice was suing Standard and Poor’s for fraud in relation to the rating of mortgage-backed securities from 2004 through 2007. My first reaction was that it is about time one of these organizations was sued, but then I thought “Why S&P and not the banks?” It is like buying a beautifully gift-wrapped box that you are assured contains gold. You open the box only to find that it is full of manure, and so you sue the maker of the gift wrap.

There are only four companies in the United States today that carry a AAA rating from S&P – ADP, Microsoft, Exxon Mobil, and Johnson & Johnson. Yet from 2000 through 2007, S&P’s peer company, Moody’s, rated nearly 45,000 mortgage-related securities as AAA. In 2006 alone, Moody’s gave AAA ratings to 30 mortgage-backed securities every day. Ultimately 83 percent were downgraded. The lawsuit against S&P quotes an internal message that said “We rate every deal … it could be structured by cows and we would rate it.”

The rating agencies were certainly enablers of the gigantic fraud that was perpetrated on the U.S. economy, but they only provided the gift wrap. What about the companies that sold manure as gold? The Fraud Enforcement and Recovery Act was passed in 2009 and established the Financial Crisis Inquiry Commission, which published a report of more than 500 pages in January 2011. Among the findings were that the number of reports of possible financial crimes filed by banks and their affiliates, related to mortgage fraud, grew 20-fold between 1996 and 2005, and then doubled again between 2005 and 2009. One study showed the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion.

Bear Stearns, Lehman Brothers, and Merrill Lynch were borrowed to the hilt with leverage ratios as high as 40 to 1. That meant that a 2.5 percent drop in the value of the assets against which they were borrowing could wipe out the firm. At the end of 2007, Bear Stearns had $11.8 billion in equity and $384 billion in liabilities, with as much as $70 billion being borrowed on the overnight market.

The Fraud Enforcement and Recovery Act also provided $165 million to the Justice Department and $70 million to other agencies to help them detect and prosecute fraud. You might ask what happened. Senators Brown and Grassley have done just that. In a letter to Attorney General Eric Holder in January, they raised the question if “too big to fail’ also means “too big to jail.” One of the factors triggering their letter was a recent statement by Lanny Breuer, who is head of the criminal division of the Justice Department and the man responsible for deciding whether anyone should be prosecuted for the financial crisis of 2008.

In an interview for a Frontline TV program, Mr. Breuer said:

I think I and prosecutors around the country, being responsible, should speak to regulators, should speak to experts, because if I bring a case against an institution, and as a result of bringing that case, there is some huge economic effect – if it creates a ripple effect so that suddenly counterparties and other financial institutions or other companies that had nothing to do with this are affected badly – it’s a factor we need to know and understand.

The senators asked the attorney general the following:

  1. Name any companies designated too big to jail.
  2. State whether the Justice Depart-ment has ever failed to prosecute such a company.
  3. State whether the Department has entered into settlements in which the amount of the settlement reflected a concern that markets could be impacted by such a settlement.
  4. Provide the names of all outside experts consulted in making prosecutorial decisions.
  5. How much did you pay these experts?
  6. How did you ensure the experts gave unbiased advice?

The senators concluded by saying “There should not be one set of rules that apply to Wall Street and another set for the rest of us.” But recent actions of the Justice Department show that there are two sets of rules. The department recently settled a case with HSBC for $1.92 billion. The allegations involved sending $800 million in cash from Mexico to the United States — the proceeds of Columbian drug cartels. There were hundreds of millions more in disguised transactions with such upstanding partners as Iran and Sudan. You might think these activities might be slightly illegal, but no criminal charges were filed. The government decided HSBC was too big to fail and too big to jail.

So perhaps we should add a corollary to Willie Sutton’s first law. Banks are not only where the money is, but also where the unindicted crooks are. And we can contradict Willie Sutton’s second law. You can rob a bank with just charm and personality as long as the U.S. Department of Justice is the prosecuting agency.

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