Inside Job (28 page)

The executives of both originators and securitizers then committed a separate form of securities fraud in their statements to investors and the public about their companies’ financial
condition. They knew that they were engaging in fraud that would eventually need to end, and as the bubble peaked and started to collapse, they repeatedly lied about their companies’
financial condition. In some cases they also concealed other material information, such as the extent to which executives were selling or hedging their own stock holdings because they knew that
their firms were about to collapse.

Next, several investment banks committed securities fraud when they failed to disclose that they were selling securities that they had designed to rid themselves of their worst loans and CDOs,
or that were designed to fail so that the investment banks and their hedge fund clients could profit by betting on their failure. The Hudson and Timberwolf synthetic CDOs sold by Goldman Sachs, and
which were the focus of the Levin Senate subcommittee hearings, provide a very strong basis for prosecution. Goldman’s trading division had been dragooned into finding and offloading their
riskiest assets to naive institutional investors—midsized German banks, South Korean banks, minor public pension funds, and the like. Important representations in the Hudson sales
material—that assets were not sourced from Goldman’s own inventory—were distorted, in ways that could be material, since investors had learned to be wary of banks clearing out
their own bad inventory. E-mail trails show that top executives closely tracked the disposals and were relieved when they managed to sell the Timberwolf assets—as they should have been, for
the assets were nearly worthless within months. There have been no prosecutions.

Many large US financial institutions, including the banks but also accounting firms, rating agencies, and insurers, were involved in other securities frauds during the bubble. We have already
noted the banks’
misrepresentations as to the safety and liquidity of auction-rate securities, for example, for which nobody has been prosecuted criminally. Similarly,
Citigroup failed to disclose in its investor presentations that it was contractually obligated to repurchase, or pay for the losses on, huge quantities of securities that it had placed in
off-balance-sheet structured investment vehicles (SIVs). (In this case, Citigroup may have a legal defence—while its investor presentations were misleading, Citigroup
did
disclose the
existence of SIV-related liabilities in the footnotes of the 10-K reports it filed with the SEC.) Similarly, AIG and the other mortgage securities insurers were also highly dishonest in their
representations to the investing public when, as the bubble peaked and started to collapse, they faced imminent financial disaster.

In some cases, we have clear evidence of senior executive knowledge of and involvement in misrepresentations. For example, quarterly presentations to investors are nearly always made by the CEO
or CFO of the firm; if lies were told in those presentations, or if material facts were omitted, the responsibility lies with senior management. In some cases, such as Bear Stearns, we have
evidence from civil lawsuits that very senior executives were directly involved in constructing and selling securities whose prospectuses allegedly contained lies and omissions. In other cases, we
do not yet have direct evidence of senior executive involvement, but such involvement is quite possible. If prosecutors forced the people directly responsible to talk, there is no question
whatsoever in my mind that many of them would implicate senior management. There are several reasons for believing this. First, the amounts of money involved were so large. Second, most firms
required senior management to approve issuance of major securities. And third, the senior management of several securitizers was dominated by people who, earlier in their careers, had been deeply
involved in similar activities, and who would be expected to monitor them closely and understand them.

Here we also have a number of known opportunities for prosecution, as well as many other likely ones. We have already seen, of course, that both Fannie Mae and Freddie Mac
allegedly engaged in massive accounting frauds for years until their discovery in 2003–2004. Those frauds resulted in no criminal prosecutions, and only mild civil penalties; some of the
individual beneficiaries were able to keep their illicit proceeds, and none were fined more than their illicit gains. The statute of limitations on those offences has now expired.

However, we also know of other major probable violations. The best known is the “Repo 105” trick by which Lehman Brothers fraudulently concealed its real level of leverage during the
bubble. Lehman’s US accounting firm, Ernst & Young, allegedly shielded themselves by insisting that Repo 105 deals be nominally run through an international subsidiary, and thus the
transactions would not be included in consolidated US numbers. Ernst & Young denies any wrongdoing and states that it followed all US rules. In late 2010, the New York State attorney general
brought a civil suit against Ernst & Young, which the firm said it would “vigorously defend”, but nobody has been prosecuted or fined for the Repo 105 deals.
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Lehman and many other securitizers also inflated the value of their assets. In Lehman’s case, the most egregious overvaluation was in its commercial property portfolio, whose overvaluation
by billions of dollars was discussed explicitly by Lehman senior management in the year prior to the firm’s collapse. Other firms such as Merrill Lynch and Citigroup inflated the value of
their mortgage-related assets—loans waiting to be securitized, CDOs waiting to be sold, pieces of CDOs that they could not sell or had decided to retain. We have already seen, for example,
that Merrill Lynch traders paid traders in another Merrill Lynch group to “purchase” mortgage securities at inflated prices when they could not be sold on the open market. In a number
of cases, these overvaluations were known and discussed within the firm; and again, some degree of senior management involvement would often be likely. Again, nobody has been prosecuted.

Joseph Cassano and AIG’s senior financial management aggressively prevented Joseph St. Denis from properly evaluating the CDS portfolio of AIG Financial Products
after AIG’s auditor had declared a material weakness in AIG’s financial statements. Both Cassano and AIG senior management also made a number of extremely inaccurate, misleading public
statements to investors and investment analysts in 2007 and 2008. AIG continued to maintain inflated values of its CDS and mortgage securities positions in late 2007 and the first half of 2008,
even though Goldman Sachs was sharply reducing its own valuations of mortgage securities and was demanding and obtaining large amounts of CDS collateral from AIG. There have been no prosecutions
related to this situation.

It seems highly unlikely that the banks’ accounting firms were never aware of these frauds. In several cases, such as the Repo 105 fraud and AIG’s accounting for its CDS portfolio,
there already exists public evidence that accounting firms realized at the time that fraud was being committed. However, there has not been a single criminal prosecution of a US accounting firm
related to the bubble.

The 1988 amendments to the US mail fraud statute include the following: “
scheme or artifice to defraud
includes a scheme or artifice to deprive another of the intangible right of
honest services.” This statute has been used to prosecute many corruption and financial fraud cases. A recent Supreme Court decision found that the statute was unconstitutionally vague, and
limited its application to cases involving bribes or kickbacks.

However, several cases would still seem to fit. Yield spread premiums, authorized and even ordered by the senior management of originators, certainly led to massive violations of any right to
honest services. Some of those lenders were owned by the banks, and others were undoubtedly pressured or incented by the banks to provide larger quantities of higher-yielding loans. There have been
zero bubble-related
honest services prosecutions of lenders or senior executives of lenders. Based on the SEC/General Accounting Office investigation, the Jefferson County
case involves, first, under-the-table fees paid by JPMorgan Chase to county officials but, even more interestingly, the same sort of payments to Goldman Sachs to induce Goldman not to bid on the
project. Nobody at JPMorgan Chase or Goldman Sachs has been prosecuted.

Finally, the rating agencies would seem to be ripe for honest services prosecutions, even within the recently narrowed scope of the statute. While their free speech defence under the first
amendment of the Bill of Rights might protect the rating agencies from many forms of civil liability, it does not protect them from criminal liability. With varying degrees of nakedness, all three
of the major rating agencies provided questionable services to investors. Many times they slanted their ratings to favour issuers who paid them; failed to disclose the extent to which they were
paid consulting fees by those issuers; failed to disclose that senior management was pressuring employees to rate unreasonably large numbers of securities, precluding any effective due diligence;
failed to disclose that when offered information (for example by Clayton Holdings) that would have improved the accuracy of ratings, they refused the information; and represented that they were
actually providing unbiased ratings services when, often, they were simply providing assembly-line high ratings for securities, many of which were later found to be fraudulent. However, there has
not been a single criminal prosecution, either for honest services violations or any other offence, of any of the major rating agencies or their executives.

It is felony perjury to lie under oath, whether in a civil deposition, in a civil trial, or when testifying before the US Congress. It is also a felony to lie to US federal
investigators.

Here, many cases might be difficult to prove, but the blunt reality is
that many financial executives did not tell the whole truth while testifying before Congress. Angelo
Mozilo testified that it was not in his or his executives’ interest to make fraudulent loans, when in fact we have seen, and Mr Mozilo evidently knew, that it
was
in his financial
interest to do this, even if it destroyed his firm.

Then there was Lloyd Blankfein. Lloyd Blankfein testified, for example, that he was unaware of the importance that ratings played in the purchasing decisions of institutional investors.
Blankfein had spent his entire career at Goldman Sachs (since 1981) in commodities and securities trading. For most of the decade before he became CEO, he was a senior executive in the Goldman
Sachs division that included its fixed-income (bond) business. The idea that he was unaware of the importance that ratings played in institutional purchases of CDOs is, to put it frankly, absurd. I
would not be surprised that if someone should take the effort to go carefully through Mr Blankfein’s e-mail and depose everyone around him, there would be plenty to indicate that he knew how
important these ratings are. His testimony before Senator Levin’s committee was also curious in maintaining that Goldman was “market making” when in fact it was knowingly selling
off its junk and betting against the resultant securities that it constructed and sold for this purpose. His colleagues’ testimony was, if anything, worse—Dan Sparks saying that he sold
Timberwolf
before
it was described as a “shitty deal” and then admitting literally ten seconds later, when nailed by Senator Levin, that, yes, they had sold it afterwards
too.

To take another example, this time from the hearings of the Financial Crisis Inquiry Commission (and yes, this was sworn testimony), here is former Citigroup CEO Chuck Prince in an exchange with
a commission member questioning him and Robert Rubin:
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“Liquidity puts” were the mechanism by which Citigroup guaranteed that it would absorb losses on mortgage securities placed in off-balance sheet SIVs. The SIV–liquidity put
mechanism had no legitimate economic purpose; it existed solely for the purpose of allowing Citigroup to misrepresent its balance sheet, and to conceal the fact that Citigroup retained the real
risks associated with the potential failure of the securities.