Fine Distinctions Regarding Responsibility

This interesting article regarding the difficulties in prosecuting financial fraud notes that the big investment houses are making fine distinctions regarding their levels of responsibility that they really shouldn't be making, and that we should be devoting greater energies to eliminating those distinctions:

In our article in the last issue [of the New York Review of Books], we showed that, contrary to the claims of some analysts, the federally regulated mortgage agencies, Fannie Mae and Freddie Mac, were not central causes of the crisis. Rather, private financial firms on Wall Street and around the country unambiguously and overwhelmingly created the conditions that led to catastrophe. The risk of losses from the loans and mortgages these firms routinely bought and sold, particularly the subprime mortgages sold to low-income borrowers with poor credit, was significantly greater than regulators realized and was often hidden from investors. Wall Street bankers made personal fortunes all the while, in substantial part based on profits from selling the same subprime mortgages in repackaged securities to investors throughout the world.

Yet thus far, federal agencies have launched few serious lawsuits against the major financial firms that participated in the collapse, and not a single criminal charge has been filed against anyone at a major bank. The federal government has been far more active in rescuing bankers than prosecuting them.

...Goldman’s report concludes that it should disclose conflicts of interest when it acts as an adviser or fiduciary to its clients. That might seem like an admission of guilt regarding Abacus. But Goldman insists that in the Abacus and similar cases it was not acting as a fiduciary—that is to say, an adviser with responsibilities to point out risks. Rather, Goldman says, it was merely a “market maker.” The law is more stringent about the disclosure requirements of an underwriter or a broker than a market maker.

A market maker trades, say, IBM stock for its clients. It may even build investments in the stock to sell, if possible, at a profit—or it may sell the stock short (that is, without owning it), because it believes it will fall in price. This is a core business for most securities firms for thousands of stocks, bonds, currencies, commodities, and other securities. Until recent regulatory legislation, market makers were also allowed to engage in so-called proprietary trading—speculation on securities they thought were overvalued or undervalued. Restrictions on that practice, known as the Volcker Rule, named after the former Federal Reserve chairman Paul Volcker, who recommended it, are still being worked out—and may well be seriously watered down under the influence of lobbyists.

But when making a market in a particular security, Goldman argues, the firm is not obligated to provide advice or disclose conflicts of interest, even if, say, it believes IBM is overpriced. Instead, the rule is that the buyer must beware.

Still, selling complex CDOs is not the equivalent to making a market in stocks or other widely traded securities. The shares of IBM and countless other stocks, Treasury bonds, and currencies are far more simple to understand and often are subject to independent research analyses. Moreover, Goldman has no involvement in IBM’s business decisions, for example. The CDOs at hand, however, were created by Goldman bankers with help from a hedge fund, and the bankers knew much more than their clients did about how risky they were. Moreover, the bankers actively sold them to investors; they did not essentially accommodate investor needs, as they might with IBM shares. The line between these activities can be fuzzy but, in our view, to sell CDOs as Goldman did is not simply to make a market in them, and we believe prosecutors should test this view in court. They should argue that those who sell complex financial products—not only Goldman but all other banks such as Deutsche Bank—owe their clients further duties as if, as Goldman points out, they were advisers with fiduciary responsibilities.

Insider trading is the one Wall Street crime that prosecutors have treated the same way they treat street crime. Today’s bankers know they could face jail time for trading clients’ shares when they have nonpublic information about the company. As a result, federal prosecutors bring about fifty insider trading cases per year, and both Wall Street and investors benefit from the confidence in US capital markets that this enforcement creates.

A strong argument can be made that the US should treat more financial activities as it does insider trading, making clear that investment firms have broad responsibilities that go well beyond mere market-making. It would require courageous prosecutors to advocate such an approach today, and any defendant would strongly protest the approach as making conduct criminal after the fact. But there are plenty of precedents and arguments for judges to find that bankers have broader responsibilities.

...If serious prosecutions of fraud by Wall Street firms are never brought, the public’s suspicion about Washington’s policies toward bankers will only grow, as will cynicism about the rule of law as it is applied to the rich and powerful. Moreover, if investing institutions and individuals come to believe that bankers cannot be trusted, the underpinnings of the market will be eroded. Without solid, well-functioning markets, the economy cannot adequately and efficiently allocate capital to high-valued uses and create jobs. Lack of ethics and corrupt behavior will channel the nation’s resources to uses that are wasteful and unproductive, as they arguably have for several decades now as too many unethical practices have gone unchallenged.