New York Attorney General Eric Schneiderman, with the support of the mortgage task force formed by the Obama administration last January and the Justice Department, has commenced the long overdue prosecution of the Big Banks for their role in triggering the financial crisis of 2008. (That is not a typo—the Justice Department has finally moved against the Big Banks.)
The case is a civil proceeding for unspecified damages against JP Morgan Chase, as successor to Bear Stearns (which it acquired with the backing of the Fed in 2008). It alleges systematic fraud against the buyers of residential mortgage backed bonds prior to the merger.
Schneiderman deserves praise for leading the effort. It is a welcome counter to self-serving assertions of Fed officials that the investors should have understood the risks that they were getting into.
Even now, the allegations in the Complaint stir outrage, though most have been known for many months. Bear Stearns bond-marketing documents are cited for touting its quality control regarding the mortgages selected for portfolios, and its ongoing monitoring of the performance of the loans after their securitization. The Complaint charges that, in contrast, Bear Stearns systematically debased the due diligence process, encouraging slipshod reviews of loan portfolios and granting waivers for non-compliant loans. It is also said to have provided limited monitoring. Even worse, it is alleged to have systematically taken money in settlement for loans acquired that immediately went into default, pocketing the settlements instead of buying back the non-performing loans from the portfolio as required.
Motive is clearly described in the Complaint. Bear Stearns was desperate to feed the beast of mortgage-backed security financing. If it took too much care in reviewing and approving loans, the originators that were the source of the mortgages would go elsewhere to do business. And if non-performing loans were extracted from the portfolios, the originators would have to buy them back. It was better to settle for a reduced payment from the originator and build up a defense fund in case things went wrong than to offend a supplier of mortgages.
Bear Stearns also owned its own originators and servicer to generate product. But their processes were equally flawed, according to the Complaint. The beast had to be fed.
The Complaint quotes numerous e-mails from Bear Sterns employees. Embarrassing e-mails peppered with foul language seem to be de rigueur in inquiries into bank misdeeds nowadays. Suffice to say, the Attorney General makes a persuasive case that the likelihood that the bond offerings would implode was the subject of widespread and explicit discussion at Bear Stearns. It seems that they knew of the problems and decided to ignore them.
It is clear that the profits from mortgage securitization were so great that it drove a venerable financial institution mad with greed. In fact it drove almost every bank mad. The Complaint lists all of the ways Bear Stearns profited from the system.
- Loan and origination fees paid to origination subsidiaries;
- Profit on the sale of warehoused and originated loans to the mortgage-backed security financing vehicles;
- Fees for underwriting the bond offerings;
- Profit from trading and making markets in the bonds; and
- Management fees and carried interests from hedge funds that Bear Stearns created to invest in the bonds.
It stands to reason that if a business consistently generates so much profit that it drives firms like Bear Stearns and its competitors insane, the market is structurally flawed. Insanity-inducing profits should not occur in a competitive, free market. Of course, such a market did not exist. Given the size of the volume of mortgages and the relatively narrow group of banks that could compete for business, the residential mortgage-backed securities business became an oligopolistic marketplace in which boundless profits could be extracted. Drunk with profits, the banks incurred risk like there was no tomorrow. Apologists for the banks can never persuasively counter this simple fact.
It is equally clear that the public was paying for these profligate profits. As is the case with insurance fraud, the cost of a fraud on the financial markets ultimately damages the public as capital funding is impaired and sources of credit are impaired. So much for the efficiency of unregulated markets, still worshipped by conservative ideologues who seem to have missed the reports of a financial meltdown in 2008!
We can thank the Congress and executive branch for allowing this fraud to occur. They sponsored a three-decade-long “Ayn Randian” experiment in deregulation of the financial sector. They allowed the banks to engage in whatever businesses they wanted and ushered in the era of the “universal” mega-banks. The lethal cocktail of ideology, venal subservience to campaign contributors, and hubris did us in, not merely the banks’ greed.
Bear Stearns and the others pulled the trigger on the financial crisis that grievously injured the worldwide economies. But the politicians gave them the loaded gun to play with. Attorney General Schneiderman’s lawsuit promises to redress the wrongs perpetrated by the banks. Implementation of financial reform laws can remove the loaded gun from the banks’ hands.