Image: Protesters hold up signs before Goldman Sachs Chairman and CEO Lloyd Blankfein testifies on Capitol Hill
JIM YOUNG  /  Reuters
Protestors hold up signs as Goldman Sachs Chairman and CEO Lloyd Blankfein prepares to testify at the Senate Homeland Security and Governmental Affairs Investigations Subcommittee hearing on "Wall Street and the Financial Crisis: The Role of Investment Banks" on Capitol Hill in Washington, April 27, 2010.
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updated 5/15/2011 12:17:42 PM ET 2011-05-15T16:17:42

"Forgive me," began Charles Ferguson, the director of Inside Job, while accepting his 2011 Oscar for Best Documentary. "I must start by pointing out that three years after a horrific financial crisis caused by massive fraud, not a single financial executive has gone to jail, and that's wrong." The audience erupted in applause.

Ferguson is not the first to express outrage over the lack of criminal cases to spring from the financial crisis, and his speech triggered a wave of similarly prosecutorial sentiments. Since that February night, financial journalists, bloggers, and who knows how many dinner party guests have debated the trillion-dollar question: When will a Wall Street executive be sent to jail?

There are those who have implied that prosecutors are either too cozy with Wall Street or too incompetent to bring cases to court. Thus, in a measured piece that assessed the guilt of various financial executives, New York Times columnist Joe Nocera lamented that "Wall Street bigwigs whose firms took unconscionable risks … aren't even on Justice's radar screen." A news story in the Times about a mortgage executive who was convicted of criminal fraud observed, "The Justice Dept. has yet to bring charges against an executive who ran a major Wall Street firm leading up to the disaster." In the same dispassionate tone, National Public Radio's All Things Considered chimed in, "Some of the most publicly reviled figures in the mortgage mess won't face any public accounting." New York magazine saw fit to print the estimable opinion of Bernie Madoff, who observed that the dearth of criminal convictions is "unbelievable." Rolling Stone, which has been beating this drum the longest and with the heaviest hand, reductively asked, "Why isn't Wall Street in jail?"

Taken from the top, these sentiments imply that the financial crisis was caused by fraud; that people who take big risks should be subject to a criminal investigation; that executives of large financial firms should be criminal suspects after a crash; that public revulsion indicates likely culpability; that it is inconceivable (to Madoff, anyway) that people could lose so much money absent a conspiracy; and that Wall Street bears collective guilt for which a large part of it should be incarcerated.

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These assumptions do violence to our system of justice and hinder our understanding of the crisis. The claim that it was "caused by financial fraud" is debatable, but the weight of the evidence is strongly against it. The financial crisis was accompanied by fraud, on the part of mortgage applicants as well as banks. It was caused, more nearly, by a speculative bubble in mortgages, in which bankers, applicants, investors, and regulators were all blind to risk. More broadly, the crash was the result of a tendency in our financial culture, especially after a period of buoyancy, to push leverage and risk-taking to the extreme.

Mortgage fraud exacerbated the bubble—as did, among other factors, lax monetary policy, failure by Congress and successive administrations to rein in Fannie Mae (FNMA) and Freddie Mac (FMCC), and weak financial regulation, itself a product of the discredited but entrenched thesis that markets are efficient and self-policing. At the banks, overconfidence in "risk management" methods (which were mostly worthless) and ill-considered compensation practices were serious contributing causes.

As this list suggests, the meltdown was multi-causal. That explanation will be unsatisfying to armchair prosecutors, but it has the virtue of answering to the complex nature of the bubble. To prosecute white-collar crime is right and proper, and a necessary aspect of deterrence. But trials are meant to deter crime—not to deter home foreclosures or economic downturns. And to look for criminality as the supposed source of the crisis is to misread its origins badly.

Consider an oft-cited example of a high Wall Street crime: Lehman Brothers' use of an accounting tactic known as Repo 105. Lehman exploited a loophole in accounting rules to sell assets, getting them off its balance sheet even as it was obligated to repurchase them a short while later. This gave it an end-of-quarter appearance of being less leveraged. Lehman used Repo 105 as early as 2001, and increasingly in 2007 and '08, when it was concerned about its reported leverage. Lehman's transactions may have been individually permissible (and were blessed by its auditor, Ernst & Young). But the seeming intent—to mislead investors—was dishonest, and the tactic raised concerns within Lehman at the time.

To prosecute it criminally, however, you would need to show willful intent to defraud, which is difficult. But suppose it were criminal. Suppose further that Richard Fuld, the firm's chief executive officer, was one of the perps. It remains, at most, a trivial event in the subsequent crash. Although Repo 105 enabled Lehman to mask $50 billion of debt, the firm's reported debt was more than $600 billion. Put differently, Lehman's net leverage ratio was either 15 times or 17 times, both sky-high. Either way, the world knew it was highly leveraged, and its solvency was a matter of intense public debate. Had Lehman presented its balance sheet with more candor, it conceivably would have suffered its crisis earlier; maybe it would have failed in July instead of September. Regardless, the cause of the failure wasn't Lehman's misguided attempt to beautify its books. It was its excessive appetite for debt, and the risk tolerance of its creditors, for years before.

This distinction may seem a quibble, but the yearning to pin the crisis on a handful of supposed criminals distorts the story we tell about it. The mortgage crisis was a societal breakdown—a massive failure of the private market, Wall Street in particular. It wasn't, fundamentally, rooted in fraud. Enron was fraud. The bankers convicted in the savings and loan scandal who dealt sweetheart loans to friends were fraudulent. These people had their hands, willfully, in the till—and knew it.

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Bankers in the '00s behaved frightfully, often with utter disregard for fiscal soundness, but in general, far more harm to the financial system was wreaked by actions that were legal. The rating agencies were a shining example. Ratings were crucial to the distribution of mortgage securities, and therefore to the bubble. The agencies sold their ratings to the very firms that were peddling the bonds, and thus were in a highly conflicted position. They did not secretly conspire to trade ratings for cash—they didn't need to. The relationship was open, and the suasion was gradual and systemic. Over time, under the influence of market pressure, and also due to their own rising comfort with the housing market, the agencies became steadily less vigilant. To call them criminal is to call the culture criminal, which is a point of rhetoric, not law. More nearly, they were part of a corrupt system that did tremendous harm.

By contrast, in another oft-cited example, when Lloyd Blankfein, CEO of Goldman Sachs (GS), testified that Goldman "didn't have a massive short against the housing market," he seemed to be spinning the facts. Other evidence suggests Goldman was indeed short. Whether or not Blankfein's testimony crossed the line into perjury (and if so, by all means charge him), it was irrelevant to the financial crisis, which long preceded it. Goldman has, more generally, suffered from the presumption that anyone who made money during the meltdown must have been guilty of something hideous (this was the reason for Blankfein's denial). I wasn't a fan of Goldman's slickness in letting a short-seller design a collateralized debt obligation that Goldman marketed to clients, for which it was sanctioned by the Securities and Exchange Commission. However, its unsavory dealmaking should not obscure that in betting, correctly, against the housing market, it helped mitigate the crash. Had more firms done as Goldman and shorted mortgages, fewer unsound loans would have been issued.

Converse to the Goldman example of punishing profits, there is an assumption that heads of failed Wall Street banks should stand trial for their failures. The most incompetent, in my opinion, was Stanley O'Neal, the former CEO of Merrill Lynch, who remained blissfully unaware that Merrill held a devastating $50 billion of CDOs until it was too late. His exit package, worth $160 million at the time, was a disgrace to the Merrill board that allowed it.

But imprisonment is a punishment for criminality—not a sociological remedy for unfairness, incompetence, or outsize losses. "To send someone to jail," says Joel Seligman, who wrote an authoritative history of the SEC and is now president of the University of Rochester, "it isn't enough to say their firm lost money, or their clients lost money."

The demands for jail sentences are buttressed by the populist notion that Wall Street is basically a Ponzi scheme. "Ponzi," of course, derives from Charles Ponzi, an immigrant financier who created a sensation in Boston in 1920 by promising 50 percent returns in 45 days. Although he claimed to be investing in postal reply coupons—buying discounted international postage and redeeming it for face value in the U.S.—Ponzi had no source of funds other than those from investors. Madoff was his carbon copy. But was all of Wall Street a copy, too?

Ferguson says yes. Recently the director slammed author Diana B. Henriques (The Wizard of Lies: Bernie Madoff and the Death of Trust) for failing to see, as Ferguson does, that Madoff shed "a ghoulishly revealing light … on what was contemporaneously happening to America's financial system and government." This overlooks some crucial distinctions. Mortgage securities had an element of Ponzi in that new financing was required to sustain people whose mortgages were under water. However, many companies would grind to a halt without refinancing. The reason they don't is that most have genuine income. This was also true of mortgage securities. The system of issuing bonds backed by mortgage payments had endured, with few hiccups, for 30 years. Mortgages were not postal reply coupons. They became, of course, hugely overextended. It is a truism that Wall Street takes a good idea to extreme, whence springs trouble. Even so, being negligent and even reckless with a viable business is not the same as cooking up a scheme in which revenue never existed.

Bubbly markets inevitably attract con men, but not every episode of wrongdoing warrants high-level prosecution. On May 3, the Justice Dept. brought a scathing civil action against Deutsche Bank (DB) claiming the bank lied about the risk in mortgages that a subsidiary endorsed as qualifying for Federal Housing Administration insurance. The case involves 39,000 loans, whose quality the Deutsche unit was required to monitor. Some 12,000 of the loans defaulted. According to the suit, Deutsche (taking advantage of the government insurance) didn't even bother to read reports detailing the loans' poor quality. The bank even reassigned the staff member dedicated to auditing the mortgages to producing more mortgages! Deutsche has denied the charges.

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The Justice Dept. has already been ripped, publicly, for failing to prosecute. It is worth noting that the U.S. attorney on the Deutsche case, Preet Bharara, is the same attorney conducting the trial of Raj Rajaratnam, the hedge fund manager convicted of insider trading. In deciding whether to bring a criminal case at Deutsche, Justice had to answer whether senior executives had intimate participation in the bad behavior. The question was complicated by the fact that Deutsche acquired the lending subsidiary only in January 2007—when, according to the Frankfurt-based investment bank, 90 percent of the loans had already been issued. If Justice did decide that higher-ups were implicated, it had to resolve whether they merely failed to monitor loan quality or actively conspired to defraud. The latter is harder to prove and presumably less frequent. In a civil action, a verdict may be based on the preponderance of evidence. A criminal case requires a stronger narrative—and a willful protagonist. One of the first prosecutions in the wake of the mortgage bust (against two Bear Stearns hedge fund managers accused of lying about the risk in their funds' portfolios) failed precisely because the e-mail evidence attesting to the defendants' state of mind was contradictory.

While it may be harder to prove criminal guilt, it's easier for people to believe that some bad actor is the cause of bad things. This is a persistent trait in the national character. Historian Richard Hofstadter identified it in 1964 as The Paranoid Style in American Politics. He was writing mostly about McCarthyism, though he recognized that paranoia isn't limited to the political Right. Nor is it always harnessed to an unworthy cause; convicting criminals, especially in high places, isn't just worthy, it's crucial to democracy.

The paranoid style, as Hofstadter defined it, has as much to do with "style" as paranoia—it's about "the way in which ideas are believed [more] than with the truth or falsity of their content." It spawned a rhetoric that tilted every question toward conspiracy, so that random or unfortunate events were seen to compose a "baffling pattern." Thus, the "sharp decline"—Hofstadter was writing about America's perceived international strength, not the price of real estate—did not "just happen." It was inevitably brought about by "will and intention."

We could follow this strain through the dismal historiography of JFK assassination buffs to the beliefs that Washington was implicated in Pearl Harbor and Sept. 11, to the anti-federalist fantasies of the far right. Such inquiries adhere to what Nassim N. Taleb, author of The Black Swan, describes as the "narrative fallacy"—the desire to impose on chaotic events a more deterministic set of causalities. Although a few people forecast the crash, most people (even in financial firms) did not. There was genuine debate over whether a bubble existed. This is not to deny the atrociously unsound, and often unethical, loan practices. It is to assert that Stan O'Neal probably did not recognize that the mortgages his firm owned were a house of cards. The evidence of bad lending was not so widely apparent as it was later. Even when subprime issuers were in a state of collapse, Ben Bernanke and his colleagues were deeply divided over whether the U.S. faced a recession. The Federal Reserve's view was a muddle. In contrast, the story that accusers tell is coherent. As Hofstadter recognized, "the paranoid mind is far more coherent than the real world."

It may seem incredible that foolishness, greed, and negligence could lead to a calamitous, long-enduring recession in which millions of people lost their jobs. But financial history is replete with bubbles and crashes. No person—no criminal, that is—caused the Great Depression. Stock manipulation (most of it, at the time, legal) was surely a factor in the Crash of '29. Exhibit A was Charles E. Mitchell, president of National City Bank. "Sunshine Charley" avidly sold securities of dubious character to hapless clients and whipped up speculation with margin loans. His trial, on charges of tax evasion, resulted in acquittal. However, the country drew the right lessons. It enacted rules for securities disclosure and created a cop on the beat (the SEC). It also established deposit insurance, which would avert future bank runs. Bankers, though not incarcerated, were shamed, thanks to electrifying public hearings.

Mitchell's closest contemporary peer is Angelo Mozilo. A flamboyant salesman, Mozilo did more at his Countrywide Financial than anyone to popularize subprime mortgages, as well as mortgages with no money down. Neither the products nor their popularization is a crime. Under Mozilo, Countrywide Financial issued billions of dollars of mortgages with apparent neglect for whether the borrowers were creditworthy. His company contributed to the heights of the bubble and to the depths of the crash. Such behavior is why financial markets require renewed, tough regulation and supervision. It's also why the compensation system must be overhauled to remove the incentive for creating ephemeral profits that ultimately go up in smoke. Congress has gone to exhaustive labors, enacting the 2,000-page Dodd-Frank reform (which, among other provisos, creates a new consumer protection bureau) to prevent a future Mozilo. To the extent the reforms may be lacking, it is up to Congress, not the Justice Dept., to make amends.

Mozilo settled civil charges with the SEC for a record $67.5 million. Regrettably, most of the fine was paid by Bank of America (BAC). Moreover, the settlement was dwarfed by Mozilo's compensation, which included (but was in no way limited to) stock sales of nearly $140 million prior to Countrywide's collapse. Prosecutors investigated Mozilo but didn't charge him. Their decision was disappointing at an emotional level, but indictments cannot be geared to repairing feelings of frustration. Lanny Breuer, head of the Justice Dept.'s criminal division, told NPR he sought to bring cases only where guilt could be proved beyond a reasonable doubt, and without filtering decisions through the screen of public opinion. This statement was remarkable only in that Breuer felt it had to be said.

Seligman says he sees "a serious enforcement effort," both civil and prosecutorial. It's hard, of course, to second-guess any specific decision not to indict. But it's worth remembering that in the American legal system, people who merely act badly or unwisely do not do time. And people who contribute to a financial collapse aren't guilty of a crime absent specific violations that make them so. We should be thankful for that. 

Copyright © 2012 Bloomberg L.P.All rights reserved.

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