AS ALL BANKERS (INCLUDING crooked ones) will readily tell you, there is nothing more important to the health of the financial system than trust and confidence.
It is therefore all the more disturbing that, since deregulation, no other major industry has broken the law so often and so seriously—behavior, moreover, that is now rarely punished. For the last quarter century even highly criminal behavior has typically resulted at most in civil settlements in which the institution admits nothing, promises not to do it again, pays a fine—and then promptly does it again. Rarely are individual executives even sued, or fined, much less criminally prosecuted. The fines are generally trivial, a minor cost of doing business, paid by the institution, or frequently, by insurance. Thus, while the housing bubble and financial crisis contain the largest and most recent episodes of financial sector criminality, they are far from isolated.
Obviously there are many honest bankers, and even through the bubble and crisis the majority of all banking transactions were performed properly. People still deposited their paychecks, paid their bills, used their credit cards; companies issued stocks and bonds. At the same time, however, there has been a sharp increase in organized, high-level criminal behavior across a wide array of financial markets, ranging from consumer lending to high-end institutional trading. This now occurs on such a large scale, and with such frequency, that it can no longer be dismissed as aberrant or exceptional. It is no exaggeration to say that since the 1980s, much of the American (and global) financial sector has become criminalized, creating an industry culture that tolerates or even encourages systematic fraud. The behavior that caused the mortgage bubble and financial crisis was a natural outcome and continuation of this pattern, rather than some kind of economic accident.
It is also important to understand that this behavior really is seriously criminal. We are not talking about walking out of a store absentmindedly and forgetting to pay, or littering, or neglecting some bureaucratic formality. We are talking about deliberate concealment of financial transactions that aided terrorism, nuclear weapons proliferation, and large-scale tax evasion; assisting in major financial frauds and in concealment of criminal assets; and committing frauds that substantially worsened the worst financial bubbles and crises since the Depression.
This might seem like an exaggeration. It’s not. Let us now review 1) the growth of financial criminality and its declining punishment; 2) the nature, severity, and consequences of illegal conduct during the bubble and financial crisis; and 3) actual and potential responses to this conduct.
THE FIRST MAJOR outbreak of deregulation-era financial crime came promptly after the Reagan administration’s deregulation of the savings and loan industry. The S&L scandal established a pattern that has intensified ever since. Since the early 1980s, financial sector criminality has sharply increased, particularly in investment banking and asset management, while prosecution and punishment have declined nearly to zero. Criminals employed by major, politically powerful banks are almost never prosecuted, and literally never imprisoned, and there is a striking disparity in treatment of identical crimes as a function of the criminals’ institutional affiliations, or lack thereof. The overwhelming majority of financial sector offenses that are criminally prosecuted are committed by asset and hedge fund managers, by individuals who provide confidential information for insider trading, or by individual investors. Thus Bernard Madoff, Raj Rajaratnam, and Martha Stewart are prosecuted; executives of Goldman Sachs, JPMorgan Chase, Citigroup, and even Lehman Brothers are not.
The S&L, leveraged buyout, and insider trading scandals of the 1980s were the only ones for which significant numbers of politically powerful bankers were prosecuted. There were several thousand criminal prosecutions, resulting in prison sentences for prominent and wealthy executives such as Charles Keating and Michael Milken. Even then, few prosecutions were directed at the core of the financial sector, in part because it had not yet become highly criminalized. The worst offenses, and most prosecutions, occurred in the industry’s periphery. Keating ran a West Coast S&L that went bankrupt; Milken worked for Drexel, which had been a small, second-tier investment bank until his arrival. Even then, however, there were disturbing signs. For example, the very well-established accounting firm Ernst & Young had deliberately failed to warn about massive accounting frauds by its S&L clients and agreed to pay fines totaling over $300 million, and some prestigious investment banks had worked for greenmailers and fraudulent S&Ls.
But it was in the late 1990s that, for the first time since the 1920s, the largest, oldest, and most important firms in finance became criminalized. The expansion and consolidation of the financial sector in the 1990s, the Internet bubble, the rising power of money in national politics, and further deregulation together created an unprecedented opportunity for bankers to make money improperly, and they seized this new opportunity with astonishing enthusiasm.
On November 7, 2011, the New York Times published an article based on its own review of major banks’ settlements of SEC lawsuits since 1996. The Times’ analysis found fifty-one cases in which major banks had settled cases involving securities fraud, after having previously been caught violating the same law, and then promising the SEC not to do so again.1 The Times’ list, furthermore, covered only SEC securities fraud cases; it did not include any criminal cases, private lawsuits by victims, cases filed by state attorneys general, or any cases of bribery, money laundering, tax evasion, or illegal asset concealment, all areas in which the banks have numerous and major violations. Here is a tour of some major cases.
ENRON, WHICH SUFFERED the largest bankruptcy in U.S. history, was the stock market’s darling in the late 1990s. Enron was also politically well connected, particularly to Republicans. Based in Texas, it was a strong supporter of Governor George W. Bush. As noted earlier, its board of directors (and its audit committee) also included Wendy Gramm, a former chairperson of the Commodity Futures Trading Commission and the wife of Phil Gramm, then the chairman of the Senate Banking Committee.
Previously a staid energy pipeline company, in the 1990s Enron expanded into energy trading, bandwidth trading, and derivatives trading in order to cash in on the deregulation of electricity production, telecommunications, and financial services. Enron’s operations were highly fraudulent, both financially and operationally, but the company continued to grow, with twenty-two thousand employees at its peak. Enron faked its bandwidth and energy trading and artificially withheld electricity supplies to raise prices, behavior that played a role in the severe electricity shortages that plagued California in 2000–2001. Enron also committed massive financial frauds to create artificial profits and to hide liabilities and losses.
But what was particularly notable about the Enron affair was that Enron’s frauds depended deeply on long-term cooperation from its accounting firm, one of the “Big Five,” and also several of America’s largest banks.
In its financial frauds, Enron’s principal technique was to create off-balance-sheet entities known as SPEs, or special purpose entities, which it used to create fictitious transactions that made streams of borrowed money look like revenues. In the years just before it collapsed in 2001, Enron’s earnings may have been overstated by as much as a factor of ten.2 Some of the world’s best-known banks knew exactly what Enron was doing and lined up for the privilege of helping it perpetrate fraud. They all did basically the same thing—namely, create sham transactions to inflate revenues or assets.
Starting in 1997, Chase Bank, now part of JPMorgan Chase, helped Enron create false gas sale revenues. The transactions involved two fictitious offshore entities, both with the same nominal director and shareholders. One of them, Mahonia, borrowed from Chase to “purchase” gas from Enron, for which it paid cash. The second, Stoneville, “sold” the same amount of gas at the same price to Enron, and was paid with long-term interest-bearing Enron notes. Behind the smokescreen, Chase was making a loan to Enron and conspiring to make the loan proceeds look like revenues. Over several years, the scam created $2.2 billion in fake gas revenues and associated profits.
Citigroup started doing the same thing in 1999, when Enron was trying to cover up a huge shortfall in projected revenues and cash flow. Citigroup agreed to help, and presto—Enron had nearly a half billion dollars of new positive operating cash flow. Enron used this trick again and again, and the total fictitious trading cash flows appear to have been on the same scale as the Chase Mahonia scam. Again, the record leaves little doubt that Citigroup knew it was enabling a fraud.3
Finally, there was Merrill Lynch. Enron asked Merrill to buy two Nigerian power barges (yes, Nigerian power barges) at an inflated price—subject to a handshake deal that Enron would buy them back. Merrill clearly understood that it was a sham transaction, but consciences were eased by a 22 percent fee. Enron later tried to weasel out of the deal, which prompted some screaming matches. Merrill eventually got its money back, although Enron had to construct another fake transaction to produce the cash. Almost simultaneously, another Merrill team helped Enron with the purely fictitious sale and repurchase of a power plant. Nothing substantive had occurred, but Merrill got a very real $17 million fee for helping Enron create fake revenues and profits.4
Enron’s accounting firm, Arthur Andersen, was criminally prosecuted and forced out of business. Several Enron executives went to prison; the former president, Jeffrey Skilling, is still serving his twenty-four-year term, while Kenneth Lay, the CEO, died shortly before commencing his sentence. Class-action lawsuits were also filed against Enron, Arthur Andersen, and the banks. A partial list of the financial settlements with the banks from both the private and public actions are shown in Table 2 below.
But not a single one of the banks, or the individual bankers, that helped Enron fake its profits was criminally prosecuted. Aiding and abetting fraud was now permissible.5
AT THE SAME time several banks were helping Enron commit accounting fraud, the Internet frenzy was driving the U.S. stock market, particularly the Nasdaq. Nearly the entire investment banking industry, its oldest and most prestigious firms very much included, fraudulently magnified the Internet bubble to gain business. The Internet bubble marked the first appearance of the new culture of dishonesty throughout mainstream finance.
Consider a priceless exchange between a Merrill Lynch broker and Henry Blodget, a youthful Merrill technology analyst, in 1998. In an internal e-mail regarding one of his favorite stock recommendations, Blodget described his private view of the company as “pos.” The broker asked Blodget why his view was “positive,” since she thought the company’s numbers looked pretty weak. Blodget helpfully explained that “pos” didn’t mean positive. It meant piece of shit.6
Morgan Stanley’s Mary Meeker, another star technology analyst, was reportedly paid oceans of money for helping Morgan Stanley secure Amazon’s investment banking business. (Both she and the bank were later sued on the basis of those conflicts.) Meeker was also deeply involved in pitching the AOL/Time Warner merger to the Time Warner board. Morgan Stanley stood to reap a large fee if the deal closed. And close it did, becoming one of the worst corporate mergers in history.7
Even Blodget and Meeker weren’t as conflicted as Jack Grubman, the telecommunications analyst at Salomon Brothers (later Salomon Smith Barney). For years, he pushed Global Crossing and WorldCom, both of which turned out to be fraudulent disasters. Grubman was especially close to Bernie Ebbers, then CEO of WorldCom, coaching him on his presentations to other analysts. Ebbers was later convicted of accounting fraud, and is still in prison. An angry broker complained that Grubman maintained his “buy” rating on Global Crossing “from $60 all the way down to $1.”
As the bubble peaked, Grubman decided to downgrade a half dozen of the companies he followed but then reversed himself at the request of the investment bankers. After long denigrating AT&T, he switched to a “strong buy” in 1999—allegedly based on the company’s new cable strategy, but really because Salomon’s new parent, Citigroup, had just won AT&T’s investment banking business.8
Such behavior was common during the Internet bubble. Particularly for dot-com companies, the divergence between investment banks’ public statements and the private views of analysts was frequently vast. Investment banks supposedly maintained “Chinese walls” between their research and investment banking departments, but it was a charade. Favorable analysts’ reports were a key marketing tool in selling investment banking services, and analysts’ pay was explicitly based on the investment banking revenues they generated. So they danced to their masters’ tune, much as the rating agencies did during the mortgage bubble.
The Internet bubble was very profitable—the volume of private placements, IPOs, mergers, and acquisitions was far greater than anything seen before on Wall Street. A very high fraction of it was fraudulent, and it caused an enormous wave of losses, bankruptcies, failed acquisitions, and write-downs in 2000 through 2002. Companies such as Excite, Infospace, pets.com, WorldCom, Covad, Global Crossing, boo.com, startups.com, Webvan, e.digital, and many others received high investment ratings from bankers shortly before collapsing. Frequently the banks also paid barely disguised bribes to individual executives in order to obtain their company’s business. But because the major investment banks all wanted IPO business, and also because they syndicated portions of most IPOs to each other, none of them was incented to be honest in their analyst research.
The Clinton administration did nothing—not the SEC, not the Justice Department, nobody. The Bush administration was no better. The SEC became interested only after the New York State attorney general, Eliot Spitzer, filed a series of highly publicized lawsuits against the leading banks, which public pressure then compelled the SEC to support. In late 2002 there was a mass settlement with ten banks for $1.4 billion for “fraudulent research reports,” “supervisory deficiencies,” and subjecting analysts to “inappropriate pressures” from investment bankers. The largest single penalty, $400 million, was paid by Citigroup, while Merrill and Credit Suisse First Boston paid $200 million each, and Goldman Sachs paid $110 million. A few mid-level analysts—very few—were prosecuted. Blodget and Grubman were barred from the securities industry for life and paid fines of $4 million and $15 million, respectively. Meeker was not fined and went on to lead Morgan Stanley’s technology research unit.9
Here are some excerpts from my interview with Eliot Spitzer.
SPITZER: Indeed, the defense that was proffered by many of the investment banks was not “You’re wrong”; it was “Everybody’s doing it, and everybody knows it’s going on, and therefore nobody should rely on these analysts anyway.”
CF: Did they really say that to you?
SPITZER: Oh yes … this was said to us. This was … And the other piece of it was, “Yes, you’re right, but we’re not as bad as our competitors, because everybody does it, and you should go after them first.” And so there really wasn’t an effort to deny that this intersection of analysts and investment bankers had generated a toxic combination. It was really, “Why are you going after us?” Again, it was the jurisdictional issue, and there were what they called Spitzer amendments floated up on Capitol Hill. Morgan Stanley went down to the House Financial Services Committee, this is when it was under Republican control, and they worked very hard with the SEC support to get an amendment through that would’ve limited and eliminated our jurisdiction and our ability to ask the questions. We beat that back with a fair bit of publicity.
Then I asked him about criminal prosecution:
CF: Did you ever think of prosecuting any of these people criminally?
SPITZER: We thought long and hard about it.
CF: Why didn’t you?
SPITZER: I’ll tell you why.… The only realistic targets in that criminal case would’ve been the analysts who are essentially mid-level individuals at the investment houses. And so I said to myself, “Yes, we could probably make a criminal case against a mid-level analyst, but the analyst is doing what he has been asked and told to do by the creation of an entire structure that preordained this outcome.” We probably won’t be able to make a criminal case against those higher up in the spectrum.
CF: Even though you think they were guilty.
SPITZER: Even though they understood that the system was generating analytical work that was flawed, it was going to be impossible to prove that the CEO knowingly instructed somebody to say something that was untrue, just because the e-mail chatter was down [t]here. As you move up the hierarchy, the CEO would say, “Well, of course we have analysts, of course they’re telling the truth. Now, do we compensate them based upon how much investment banking business they bring in? Sure, but I never said to them, ‘Lie.’ ” But the lies flowed almost necessarily from the system that was created.
CF: Was it, and is it, your personal opinion that the senior people were in fact guilty?
SPITZER: My view is that anybody within the investment bank was aware of the fact that the analytical work was tainted by the desire to bring in investment banking business, and that … the entire business model depended upon it.…
So if you use the word “guilty” in a generic sense, yes, they were guilty of knowing that something was wrong. Guilty in a sense that they were provably guilty of a criminal case is a very different matter.
CF: Not provably. My question was not about … I understand your point about proof. But there’s a difference between proof and what your opinion is about their real culpability.
SPITZER: Were they guilty of knowing that the analytical work was being tainted and damaged by the desire to get investment banking business? Yes.
Part of Spitzer’s reluctance to prosecute may have come from the realities of his situation. He had fewer than twenty attorneys dealing with the investment banks, who outspent him at least ten to one; the Bush administration and the SEC were, to put it mildly, unenthusiastic; and although the offenses and their damage were serious by the standards of the time, they were utterly trivial compared to those committed since. The question of proof is, of course, an important one, and we will return to it in considering the mortgage bubble and the financial crisis.
MUNICIPAL BOND ISSUANCE is one of the murkier backwaters of finance, as subprime mortgages used to be. It is also notoriously corrupt, and left a wake of extraordinary destruction in Alabama’s Jefferson County, which includes the city of Birmingham.10
In the late 1990s, Jefferson County settled a long-running dispute with the EPA by undertaking a major sewer project, financed with $2.9 billion in long-term fixed-rate bonds with an interest rate of 5.25 percent. As rates fell in the early 2000s, bankers descended on the county offering to restructure the debt and save millions in interest payments. JPMorgan Chase led a group of thirteen banks in structuring the deal and allocating its components. Instead of simply refinancing with straightforward fixed-rate bonds at a lower rate, the banks created an artificially complex deal to increase their fees. They issued $3 billion in various floating-rate instruments, while supposedly offsetting the risk of rate increases with interest-rate swaps. JPMorgan Chase used instruments called auction-rate securities, which caused billions in losses for many cities in 2008, along with other variable-rate bonds.
According to Bloomberg, the banks earned $55 million in fees for selling the auction-rate securities. The interest-rate swap contracts generated another $120 million in fees, which, according to an analyst later engaged by the county, was about six times the market norm. JPMorgan Chase was able to make this deal because it also made under-the-table payments of $8.2 million to local officials and brokerage firms. The largest payments, however, were made to other banks, including $3 million to Goldman Sachs and $1.4 million to Rice Financial Products, a New York municipal bond specialist, for agreeing to withdraw from the competition. All of the illicit payments were charged as fees deducted from the funds raised for the county. Naturally, there was no disclosure of the payments in the bond prospectuses.
At first the overall deal, leaving aside the inflated banking fees and bribes, appeared to work. The county commissioners bragged about their financial prowess, and Morgan helped them set up seminars for other counties. But when the exotic bonds that JPMorgan Chase had recommended collapsed during the financial crisis of 2008, the transaction turned into a disaster. When the county announced that it would exit the deal, JPMorgan Chase billed the county $647 million, and threatened to sue.*
As this is written, the county has defaulted on most of its debt and declared bankruptcy. The sewage improvements may never be completed, and sewage and water rates have risen to the point where poorer residents must choose between heat and water. The SEC forced JPMorgan Chase to drop its breakup fee and to pay the county $50 million in damages on top of a $10 million fine. The local prosecutor has won prison sentences for the corrupt county commissioners.
But what of JPMorgan Chase? Bribe paying is unambiguously criminal, and it is particularly obnoxious for wealthy men in elegant clothes to extract $175 million in fees from county ratepayers, most of whom are poor—and then wreak utter havoc on their government. But JPMorgan Chase has not been prosecuted. The two JPMorgan Chase executives primarily involved were fined and barred from the securities industry, but they were not prosecuted either, even though one of them had a prior criminal record for a similar offense.
Jefferson County was not alone, although its story was worse than average. By 2008 there was between $300 billion and $350 billion in auction-rate securities (ARS) outstanding, issued by thousands of state and local government entities. Investors were institutions and high-end retail investors, attracted by the money-market-like liquidity, at slightly higher yields. The minimum retail investment was usually $25,000.
AUCTION-RATE SECURITIES ARE the kind of complex product Wall Street loves to create. They make it look like bond sellers are getting a better deal, so they will cough up higher fees, without understanding the risks that lie in ambush down the road. They offer bondholders a long-term debt deal at apparently low floating interest rates. But the “long-term” part of the deal is a fake. What really happens is that the banks reauction the notes every three weeks or so to reset the rates and allow the investors to depart. But what happens if nobody bids at the reauction? Rarely but occasionally, ARS auctions had failed before the crisis. In those cases, the investment bank that had underwritten them stepped in as a short-term buyer until markets settled. But thousands of auctions failed during 2008, because investors pulled their money out of everything except Treasury bonds in a massive flight to safety. And as the banks’ balance sheets started filling up with billions in failed auction securities, they collectively stepped aside and let the market collapse.11
As a result, issuers were suddenly faced with the need to pay prohibitively high rates, and many defaulted. The resulting collapse of the ARS market wiped out the nest eggs of investors all over the country, as they found themselves with defaulted and illiquid securities. State attorneys general initiated lawsuits, as did class-action plaintiffs, and eventually the SEC. Nearly always, the banks’ sales brochures and presentations had represented ARS as “completely liquid,” “as good as cash,” or as “money market instruments”; and the banks’ sales forces continued to make such representations long after the industry was aware of the looming collapse of the entire ARS market.12
Settlements with twenty-one banks and investment banks were reached in 2008 and 2009. UBS agreed to buy back $22 billion worth of ARS; Merrill Lynch, $19.5 billion; Wachovia, $9 billion; Morgan Stanley, $4 billion; and JPMorgan Chase, $3 billion.13
But the ARS fiasco is just one example of the high levels of predation and corruption found in municipal bond markets. A consortium of state attorneys general, the Justice Department, and the SEC has been pursuing a long-running bribery and bid-rigging case involving more than a hundred municipalities and several large banks. Bribery and fraud settlements have so far been reached with JPMorgan Chase, Bank of America, Wachovia, and UBS for multiple conspiracies with each other, with municipal officials, and with corrupt bid managers who steered municipal bond contracts to banks.14 The cases were settled with fines, and no bank or senior bank executive has been prosecuted, although several lower-level individuals have been. There have also been similar “pay to play” scandals in the market for managing local and state government pension funds. One such scandal in New York involved Steven Rattner, a prominent hedge fund manager and Democratic fundraiser who was once a strong candidate to become treasury secretary in the Obama administration. Rattner reached settlements with the SEC and the New York attorney general, agreeing to pay $16 million in fines. Obama appointed him to run the administration’s rescue of the automobile industry following the bankruptcies of GM and Chrysler.
In 2010 Barclays Capital (which contains the remnants of Lehman Brothers’s investment banking arm) began working with Del Monte Foods to arrange the sale of the company to one or more private equity firms. However, instead of solely representing Del Monte’s interests, Barclays secretly began to work with KKR and Vestar, helping them to coordinate a joint bid rather than generating a competitive auction. This violated the terms of Barclays’s contract with Del Monte and allowed KKR and Vestar to buy the company far less expensively. Barclays’s motivation was that it wanted the private equity firms’ business in arranging the financing of the acquisition, which would bring Barclays lucrative fees. Indeed, once the deal was arranged, Barclays switched sides and began working with the consortium of private equity firms that eventually won the deal—KKR, Vestar, and Centerview. A Delaware judge found that Barclays had “indisputably crossed the line” in its conduct.15
There have long been suspicions that similar behavior is widespread—that investment banks steer business to the private equity firms that they work with repeatedly, to the disadvantage of real-economy corporations seeking financing, mergers, acquisitions, or divestitures. There have been no criminal prosecutions for this conduct, in either the Del Monte case or any others.
NOT ALL CRIMINAL banking is American. In the domain of large-scale tax evasion, Swiss banks are way ahead, as is natural given Switzerland’s long-standing economic dependence on bank secrecy to attract flight capital and criminal assets. Switzerland and more than a dozen other countries including Liechtenstein, the Channel Islands, and several Caribbean nations facilitate tax evasion and asset concealment through their national banking laws. Frequently, major banks have actively assisted wealthy individuals and corporations in using these nations for those purposes. Annual tax revenue losses, just for the United States, are estimated at $100 billion.16
The following discussion of tax evasion concentrates on UBS, but investigations have uncovered similar behavior at Credit Suisse, HSBC, Julius Baer, and other European banks. Very unusually, there have been a few criminal prosecutions, although both corporate and individual defendants have been treated very leniently.
Bradley Birkenfeld, an American, worked for a UBS business unit that specialized in helping wealthy Americans evade taxes. For more than a decade, in a systematic effort authorized by the highest levels of UBS, bankers created secret numbered accounts, arranged for offshore funds transfers through shell companies, and provided offshore-sourced credit cards (to pay for expensive foreign vacations, say). UBS bankers traveling to the United States carried specially encrypted laptops to hide their files; money was transferred by hand-carried paper checks instead of wire services; sometimes bankers smuggled diamonds or other valuables. They were instructed not to stay in the same hotel on consecutive nights, and never, ever communicate with their clients on UBS letterhead.
Then Bradley Birkenfeld became a whistle-blower in 2007. Birkenfeld explained to Justice Department and IRS officials that UBS had “$20 billion” in American tax evasion accounts, with estimated profits of $200 million a year. The IRS later estimated that the accounts totaled $18 billion; and Birkenfeld’s profit estimate is probably low.
A series of Senate hearings in 2008 publicized UBS’s behavior and yielded highly embarrassing televised testimony by UBS executives, who refused to provide the names of their U.S. tax evasion clients. Shortly after the hearings, the Justice Department indicted UBS and a number of its executives, including Raoul Weil, CEO of UBS Global Wealth Management and a member of the UBS Executive Board. Weil failed to surrender after his indictment and became a fugitive. Another senior executive pled guilty and received five years’ probation. In 2009 the Justice Department and UBS reached a deferred prosecution agreement that required UBS to cooperate in identifying at least ten thousand tax evasion cases, and to pay a $780 million fine, but allowed the bank to avoid criminal prosecution. Shortly afterward, nearly fifteen thousand Americans responded to a reduced-penalty offer for voluntary disclosure.
Although Birkenfeld voluntarily came forward to unveil the entire UBS tax evasion apparatus, he was prosecuted and is now in prison. Thus far he is the only person sent to jail.
Phil Gramm, the former senator from Texas who was chairman of the Senate Banking Committee when Republicans controlled the Senate, is now vice chairman of UBS, which he joined immediately upon retiring from the Senate in 2002. As a senator, Gramm had strenuously opposed efforts to control money laundering and bank secrecy.
Many other investigations are continuing. The Germans and British have filed actions against UBS. In July 2011 the Justice Department notified Credit Suisse that it was the target of a similar investigation, and in November 2011 Credit Suisse, under threat of prosecution, began the process of disclosing tax evasion clients to the IRS. Other European and American whistle-blowers have already revealed large-scale tax evasion efforts assisted by Julius Baer and by Liechtensteiner Fürsten-Bank. The total value of the concealed assets already under investigation probably exceeds $100 billion.
TAX EVASION IS not the only motive for bank secrecy, money laundering, and asset concealment.17 Kleptocratic political leaders, organized criminals, drug cartels, and rogue states engaged in nuclear weapons development or terrorism also require bank secrecy to conceal the size and sources of their funds and to give them secret access to payments systems. Many of the world’s largest banks, both American and foreign, have been only too happy to help.
Perhaps the most extraordinary case involves Credit Suisse, Barclays, Lloyds, and seven other (as yet unidentified) international banks that laundered billions of dollars for Iran and other nations; all of the nations in question have been placed under international sanctions for developing nuclear weapons and/or supporting terrorism. In violation of UN sanctions and U.S. law, the banks helped Iran launder transfers to the United States, including payments related to Iran’s ballistic missile and nuclear programs, as well as funds that apparently were channeled to terrorist groups in the Middle East. Some banks created internal instruction manuals to help employees strip out incriminating data from wire transfers.
The most detailed public records pertain to Credit Suisse, possibly the most aggressive in marketing its program, which started violating U.S. sanctions on Iran in 1995. The bank produced a special pamphlet for its illegal customers, “How to Transfer USD Payments,” and set up a special “investigations” office to manually review each illegal transaction, promising, “It is absolutely impossible that one of your payment instructions will be effected without having it checked in advance by our specially designated payment team at Credit Suisse in Zurich and all team members are most professional and aware of the special attention such payments of yours do require” [emphasis in original]. The bank also maintained a sub-business of making transfers to “specially designated nationals,” like warlords or other large-scale criminals.18
A series of settlements reached by the banks with the Justice Department and the Manhattan District Attorney in 2009 and 2010 yielded $1.2 billion in fines. Credit Suisse agreed to pay $536 million, Barclays $298 million, and Lloyds $350 million. For at least a decade, they had systematically engaged in criminal activity by laundering money for Libya, Iran, Sudan, Burma, and North Korea, among others.19 It is clear that these activities were known and approved by quite senior executives. But since none of the three banks contested the charges, and all disclosed their records, the cases were settled with fines and deferred prosecution agreements. No bank was required to plead guilty, and not a single person was criminally prosecuted or even individually fined.
Let me pause to ask readers the following question. What do you think would happen to you, personally, if, as an individual, not a senior bank executive, you were caught laundering money for Iran’s nuclear weapons program? Do you think that, perhaps, you might be treated just a little bit more harshly? Well, in fact, we have some interesting comparative data on this question. In 2011 an Iranian American, Reza Safarha, was indicted, tried, convicted, and sentenced to ten months in prison for transferring $300,000 to Iran in violation of U.S. sanctions. He was engaged in low-level trafficking in stolen office equipment and had no involvement with the Iranian government, much less its nuclear programs or support for terrorism.
Even more striking is the case of Mahmoud Reza Banki, an Iranian immigrant who earned a PhD in the United States and worked for an American consulting firm. Over several years, he received a total of $3.4 million from his family in Iran. The money was legally earned, and he reported it on his tax returns; there was never any suggestion that he had committed any crime except violating the sanctions. It is even unclear that the transfers were substantive violations, because personal transfers to family members are exempted. Nonetheless in 2010 Banki was arrested, prosecuted, convicted, and sentenced to two and a half years in federal prison. His conviction was overturned upon appeal, and as of this writing he awaits retrial. It does not appear that he was ever offered a deferred prosecution agreement.20
The banks’ Iranian sanctions violations were particularly egregious, but far from isolated. JPMorgan Chase dipped its toes into money laundering at about the same time. In 2005 and 2006 the company processed $178.5 million in clearly illegal wire transfers from Cuban nationals. Treasury officials also caught the bank processing illegal wire transfers to Sudan. At first the bank denied it, but after being pressed, it produced documents confirming the transactions. Although Treasury officials called JPMorgan Chase’s behavior “egregious,” the case was settled for an $88.3 million fine.21
The single most notorious money-laundering episode related to political corruption was probably Citigroup’s assistance in smuggling $100 million out of Mexico, mostly to Switzerland, for Raúl Salinas and his wife in the 1990s. Raúl Salinas was the brother of Carlos Salinas de Gortari, Mexico’s president from 1988 to 1994, who was notorious for large-scale corruption. The discovery of the smuggling, together with an enormous scandal in Mexico involving money laundering and political assassinations, resulted in Raúl Salinas’s arrest for murder in 1995. Citigroup was never prosecuted. A GAO report prepared for Senator John Glenn made it clear that Citigroup did not follow proper procedures, but left doubt as to whether the smuggling was systematic policy or an arrangement made solely by local executives.22
There have been other cases involving corrupt rulers. In 2004 and 2005 Riggs Bank, one of the oldest and most traditional banks in the United States, paid two fines totaling $41 million, and pled guilty to criminal charges related to money laundering for Saudi Arabian diplomats, the astonishingly corrupt dictator of Equatorial Guinea, and former Chilean military dictator Augusto Pinochet, who turned out to have over $10 million in secret personal assets at Riggs. The bank received a suspended sentence and continues to operate; no executives were prosecuted.23
But these cases, while striking, were actually small compared to the money-laundering activities that U.S. banks allowed in support of the Latin American drug trade. The biggest recent case—and it was pretty damned big—involved Wachovia. Wachovia was the sixth-largest lender in the United States when it collapsed in 2008, having lost $30 billion as a result of its highly dubious real estate lending during the bubble. Shortly afterward, it was acquired by Wells Fargo. But Wachovia had another problem too.
Over the previous three years, federal grand juries had served Wachovia with 6,700 subpoenas related to its role in transferring a stunning $378 billion, most of it in cash, between Mexican currency exchanges and the United States—without reporting any transactions for suspicious behavior, of which there was an awful lot. In fact, since 2004 Wachovia had ignored or suppressed multiple internal warnings about highly suspicious funds transfers and had marginalized the compliance officers issuing the warnings. For example one compliance officer, a former Scotland Yard investigator, had found numerous, supposedly separate, Mexican transfers made at the same location and the same time, involving sequentially numbered traveler’s checks totaling enormous sums of money. He was instructed by his management to stop examining American transactions, and Wachovia’s managing director for compliance sent him a letter warning him that he was “failing to perform at an acceptable standard.” He sued Wachovia, which paid him an undisclosed amount for damages—on the condition that he leave the bank.24 The currency exchanges were ideal laundering facilities for drug cartels receiving proceeds from their American drug distributors. Funds processed by Wachovia and also by Bank of America between 2004 and 2007 were traced to the purchase, among other things, of a dozen large commercial jets used for smuggling dozens of tons of cocaine.25
Wells Fargo, as the successor/owner of Wachovia, cooperated with the investigation and agreed to pay a $160 million fine and implement a robust money-laundering detection system. Similar settlements for similar violations were reached with Bank of America and twice with subsidiaries of American Express. Amex paid a $55 million fine when its Edge Act subsidiary, AEBI, was caught facilitating money laundering for Colombian drug lords in cooperation with the Black Market Peso Exchange from 1999 through 2004.26
And then there is Bernie Madoff—or rather, the banks’ treatment of him.
BERNARD L. MADOFF, philanthropist, reliable friend, former chairman of the Nasdaq stock exchange, and creator of one of the first electronic trading platforms, also ran the biggest pure Ponzi scheme in history, operating it for thirty years and causing cash losses of $19.5 billion.27
Shortly after the scheme collapsed and Madoff confessed in late 2008, evidence began to surface that for years, major commercial and investment banks had strongly suspected that Madoff was a fraud. None of them reported their suspicions to the authorities, and several banks and bankers decided to make money from him, without, of course, risking any of their own funds. Theories about his fraud varied. Some thought he was “front-running,” examining the orders passing through his electronic trading business and then using this information to place his own trades in front of them. Some thought he might have access to insider information. But quite a few thought that he was running a Ponzi scheme.
Madoff claimed to be tracking the S&P 500 stock index, while using options to slightly increase returns while reducing volatility in the value of his portfolio.
But there were just a few little problems. For instance:
• When others tried to replicate Madoff’s strategy or apply it retrospectively, they found that his results could only be achieved by always buying at or near the market’s low and always selling at or near the market’s high—which is impossible. Madoff claimed to have had negative monthly returns only five times in fifteen years of operation. In one period in 2002 in which the S&P 500 lost 30 percent, Madoff claimed that his fund was up 6 percent. Such performance was both inconsistent with his supposed strategy and totally unprecedented in investment fund management.
• Although Madoff’s stated strategy entailed massive trading volumes in both shares and options, no one knew who his trading counterparties were, nor was there ever any visible sign of his moves in and out of the market. Actually pursuing his strategy would often have required trading more options than existed in the entire market.
• Madoff simultaneously served as the broker executing the trades, the investment advisor, and the custodian of the assets. Such an arrangement obviously lacks checks and balances and is conducive to fraud. It is unheard of for an operation on the scale of Madoff’s, and was repeatedly noted as a danger sign. Madoff also employed his brother, niece, nephew, and both of his sons in his business.
• His auditing firm was a totally unknown three-person firm in a suburban strip mall. One of the three was a secretary, and one was a semiretired CPA who lived in Florida. The firm was not professionally qualified to perform audits and did not hold itself out as an auditor.
• Account statements were typed, not electronically printed, and the firm used only paper trading tickets, both of which were inconsistent with the required volume of trading. Investors were never given real-time or remote electronic access to their account information; they only received paper statements in the mail.
• Despite his enormous purported success, Madoff did not charge any hedge fund management fees. He claimed that he made his money simply by having his own trading platform process all of his trades, a highly implausible claim. The real reason that he did not charge the typical 20 percent of profits was that he needed to attract new money to keep the scheme going as long as possible.
These problems and many others—we’ll get to those in a minute—were repeatedly cited as warning signs by banks and hedge funds that either dealt with Madoff or were considering doing so. Goldman Sachs executives paid a visit to Madoff to see if they should recommend him to clients. A partner later recalled, “Madoff refused to let them do any due diligence on the funds and when they asked about the firm’s investment strategy they couldn’t understand it. Goldman not only blacklisted Madoff in the asset management division but banned its brokerage from trading with the firm too.”28 Risk managers at Merrill Lynch, Citigroup, UBS, JPMorgan Chase’s Private Banking, and other firms had done the same. The Merrill parent company, for example, had expressly forbidden dealings with Madoff from the 1990s.29 They all suspected fraud of some kind.
As a result, most of the major banks declined to invest their own money with Madoff. However, they did sometimes allow their clients to invest. A number of banks, including Merrill Lynch, Citigroup, ABN Amro, and Nomura, also created various tracking funds to replicate Madoff’s returns,* even though all suspected fraud.
But UBS and JPMorgan Chase were even more deeply involved. UBS created a new family of “feeder funds” to send assets to Madoff. (Madoff generally did not accept direct investments, preferring to receive money via these “feeder funds.”) Most feeder funds acted as little more than drop boxes and made few, if any, investments except into Madoff’s fund. There is strong evidence that several of them knew Madoff was a fraud. But Madoff paid them about 4 percent per year for doing virtually nothing, so they were happy to look the other way.
UBS created or worked with several Madoff feeder funds, even though UBS headquarters forbade investing any bank or client money in Madoff accounts. The feeder funds were required by law to conduct due diligence, and one of them hired a due diligence specialist named Chris Cutler. After four days, he wrote to the feeder fund: “If this were a new investment product, not only would it simply fail to meet due diligence standards: you would likely shove it out the door. EITHER extremely sloppy errors OR serious omissions in tickets.” Cutler found, for example, that Madoff’s claimed strategy implied trading a number of options that was far higher than the total number actually traded on the Chicago Board Options Exchange.30 The fund proceeded with its Madoff investments anyway.31
UBS explicitly instructed its employees to avoid Madoff. A memo to one of the feeder funds in 2005 contained a section entitled “Not To Do.” In this section was the following, in large boldface type: “ever enter into a direct contact with Bernard Madoff!!!” One of the UBS executives involved in creating the new funds received a headquarters inquiry on what he was doing. He replied, “Business is business. We cannot permit ourselves to lose 300 million,” referring to anticipated fund management revenues.32 UBS proceeded to issue fund prospectuses in which it represented that it would act as custodian, manager, and administrator of the feeder funds, when in fact they had already agreed with Madoff to play no such role. Like all Madoff sponsors, UBS received no information except paper summaries of monthly results.
JPMorgan Chase was, if anything, even more dishonest. Like Merrill Lynch and Citigroup, they set up Madoff tracking funds despite explicit warnings from an executive in JPMorgan Chase’s Private Bank unit that he “never had been able to reverse engineer how [Madoff] made money.”33 But JPMorgan Chase had even more evidence, because they served as Madoff’s primary banker for more than twenty years.* Anyone with access to those accounts would know that something was seriously wrong. For example:
• An investment company with thousands of individual customers should have credited incoming funds to segregated customer accounts or directed them into multiple other subaccounts. Instead whatever came in was more or less tossed into a single pot.
• Know Your Customer (KYC) rules for business accounts were greatly strengthened after 9/11, and JPMorgan Chase allegedly takes its KYC obligations very seriously. There is a KYC department attached to every line of business. But the identified KYC “sponsor” on the Madoff account, when interviewed by the Madoff bankruptcy trustee, was unaware that he had been so designated and did not know what the job entailed.
• JPMorgan Chase received copies of the mandatory financial filings that Madoff made with the SEC. They were usually wrong, often wildly so. One statement listed $5 million in bank cash accounts, when the actual amount at JPMorgan Chase was $295 million. Another listed no outstanding bank loans, when there was a $95 million loan outstanding. For years, the statements showed no trading commission revenue, even though they were supposed to be the primary source of Madoff’s income (he did not charge management or incentive fees). Then one year, the statements suddenly showed more than $100 million in commissions, although none were in the product categories that were supposed to dominate his strategy. Madoff’s prospectuses represented that idle cash was always invested in Treasury bills, when JPMorgan Chase knew it was almost all in overnight deposits.
• Money-laundering regulations are quite strict and impose obligations on banks to report suspicious activity. JPMorgan Chase has an automated alert system that is supposed to trigger a review and report whenever a “red flag” event occurs. How about a customer who received 318 transfers of exactly $986,310 each in a single year, often several per day? No problem, no alert.
• Several of Madoff’s biggest customers were also JPMorgan Chase Private Banking customers, so the bank could see both sides of the transactions. And indeed they often saw hundreds of millions of dollars washing back and forth between client accounts and Madoff, sometimes billed as loans but often with no explanation at all. In the entire history of the Madoff accounts, the automated money-laundering system generated only a single alert, which was not followed up.
With all that, they must have suspected something—and indeed they did. The lawsuit filed by the Madoff bankruptcy trustee against JPMorgan Chase makes for astonishing reading. More than a dozen senior JPMorgan Chase bankers had discussed in e-mails and memoranda, as well as in person with each other, a long list of suspicions. On June 15, 2007, one employee said to another: “I am sitting at lunch with [redacted] who just told me that there is a well-known cloud over the head of Madoff and that his returns are speculated to be part of a Ponzi scheme.” At the same time—June 2007—three members of JPMorgan Chase’s executive committee openly discussed this possibility at a meeting. They were John J. Hogan, chief risk officer for investment banking; Matthew E. Zames, a senior trading executive; and Carlos M. Hernandez, head of equities for the investment banking unit. After Madoff’s arrest, Hogan’s deputy, Brian Sankey, suggested that it would be preferable if the meeting agenda “never sees the light of day again.”34 But Madoff produced a half billion dollars in fee revenue for JPMorgan over the years, so the bank clearly had no interest in rocking that boat.
The SEC has been deservedly criticized for not following up on years of complaints about Madoff, many of which came from a Boston investigator, Harry Markopolos, whom they treated as a crank. The SEC also bungled its own investigations of Madoff. But suppose a senior executive at Goldman Sachs, UBS, or JPMorgan Chase had called the SEC director of enforcement and said, “You really need to take a close look at Bernard Madoff. He must be working a scam. No proof, but here are five very suspicious facts, and here’s what you should look for.” If it came from them, the SEC would have had to pay attention, even in the pitiful, toothless state to which it had been reduced in the Clinton and Bush administrations. But not a single bank that had suspicions about Madoff made such a call. Instead, they assumed he was a crook, but either just left him alone or were happy to make money from him.
TAKEN TOGETHER, THE foregoing suggests a major cultural change in American and global banking, and in its treatment by regulators and law enforcement authorities. Since the 1980s finance has become more arrogant, more unethical, and increasingly criminal. Tolerance of overtly criminal behavior has now become broadly, structurally embedded in the financial sector, and has played a major role in financial sector profitability and incomes since the late 1990s. In some cases, financial criminality has supported truly grave offenses (nuclear weapons proliferation), while in other cases it has been a major contributor to financial instability and recession (the S&L crisis, the Internet bubble).
And yet none of this conduct was punished in any significant way. Total fines for all these cases combined appear to be far less than 1 percent of financial sector profits and bonuses during the same period. There have been very few prosecutions and no criminal convictions of large U.S. financial institutions or their senior executives. Where individuals not linked to major banks have committed similar offenses, they have been treated far more harshly.
Given this background, it is difficult to avoid the conclusion that the mortgage bubble and financial crisis were facilitated not only by deregulation but also by the prior twenty years’ tolerance of large-scale financial crime. First, the absence of prosecution gradually led to a deeply embedded cultural acceptance of unethical and criminal behavior in finance. And second, it generated a sense of personal impunity; bankers contemplating criminal actions were no longer deterred by threat of prosecution.
My own conclusion after having examined this subject is that if the Internet bubble, the abetting of frauds at Enron and elsewhere, and the money-laundering scandals had resulted in prison sentences for senior financial executives, the financial crisis probably would have been far less serious, even if financial deregulation had occurred just as it did at the policy level. The law still leaves considerable scope for dangerous and unethical behavior, but many of the abuses of the bubble depended upon criminality.
And just as the last twenty years of unpunished crime constituted a green light for the bubble, so, too, America’s nonresponse to the bubble and crisis is setting the tone for financial conduct over the next decade. Beyond an interest in justice for its own sake, it is therefore important to consider whether the behavior that generated the bubble was criminal, whether successful prosecutions are feasible, and whether putting senior financial executives in prison on a large scale would be ethically justified and economically beneficial.
The Obama administration has rationalized its failure to prosecute anyone (literally, anyone at all) for bubble-related crimes by saying that while much of Wall Street’s behavior was unwise or unethical, it wasn’t illegal. Here is President Obama at a White House press conference on October 6, 2011:
Well, first on the issue of prosecutions on Wall Street, one of the biggest problems about the collapse of Lehmans [sic] and the subsequent financial crisis and the whole subprime lending fiasco is that a lot of that stuff wasn’t necessarily illegal, it was just immoral or inappropriate or reckless. That’s exactly why we needed to pass Dodd-Frank, to prohibit some of these practices. The financial sector is very creative and they are always looking for ways to make money. That’s their job. And if there are loopholes and rules that can be bent and arbitrage to be had, they will take advantage of it. So without commenting on particular prosecutions—obviously that’s not my job; that’s the Attorney General’s job—I think part of people’s frustrations, part of my frustration, was a lot of practices that should not have been allowed weren’t necessarily against the law.35
In these and many other statements, the president and senior administration officials have portrayed themselves as frustrated and hamstrung—desirous of punishing those responsible for the crisis, but unable to do so because their conduct wasn’t illegal, and/or the federal government lacks sufficient power to sanction them. With apologies for my vulgarity, this is complete horseshit.
When the federal government is really serious about something—preventing another 9/11, or pursuing major organized crime figures—it has many tools at its disposal and often uses them. There are wiretaps and electronic eavesdropping. There are undercover agents who pretend to be criminals in order to entrap their targets. There are National Security Letters, an aggressive form of administrative subpoena that allows federal authorities to secretly obtain almost any electronic record—complete with a gag order making it illegal for the target of the subpoena to tell anyone about it. There are special prosecutors, task forces, and grand juries. When Patty Hearst was kidnapped by the radical Symbionese Liberation Army in 1974, the FBI assigned hundreds of agents to the case.
In organized crime investigations, the FBI and federal prosecutors often start at the bottom in order to get to the top. They use the well-established technique of nailing lower-level people and then offering them a deal if they inform on and/or testify about their superiors—whereupon the FBI nails their superiors, and does the same thing to them, until climbing to the top of the tree. There is also the technique of nailing people for what can be proven against them, even if it’s not the main offense. Al Capone was never convicted of bootlegging, large-scale corruption, or murder; he was convicted of tax evasion.
In this spirit, here are a few observations about the ethics, legalities, and practicalities of prosecution related to the bubble:
First, much of the bubble was directly, massively criminal. One can debate exactly what fraction, where the gray areas are, how much of it can be proven, and so forth. But it sure as hell wasn’t zero. And we’ll take another little tour of the industry shortly, with this question in mind.
Second, if you really wanted to get these people, you could. Maybe not all of them, but certainly many. Some bubble-related violations are very clear, with strong written evidence. If you flipped enough people, some of them would undoubtedly have interesting things to say about what their senior management knew. And many of the people responsible for the bubble are the same people responsible for the other crimes we just examined that have not been seriously pursued or punished. Many of these people have also committed various personal offenses—drug use, use of prostitution, tax evasion, insider trading, fraudulent billing of personal spending as business expenses. Many of them still have their original jobs and are therefore subject to regulatory oversight and pressure, as are their firms. In fact, there are many techniques, venues, organizations, regulations, and statutes, both civil and criminal, available to investigate these people, punish them, and recover the money they took—if you really wanted to. The federal government has used almost none of them.
Third, the moral argument for punishment is very strong, providing ample justification for erring on the side of aggressive legal pursuit. Whatever portion of banking conduct during the bubble was criminal, it was certainly substantial, and there is no doubt whatsoever that it was utterly, pervasively unethical, designed to defraud in reality if not in law. Since the crisis, the people who caused it have been anything but honest or contrite. They have been evasive, dishonest, and self-justifying, returning as quickly as possible to their unerringly selfish behavior. Their behavior caused enormous damage, both human and economic; the consequences of their wrongdoing are so large as to justify almost any action that could help to prevent another such crisis by creating real deterrence. There would also be intangible but large benefits to raising the general ethical standard of a vital industry, and one whose executives often become high-level government officials.
Given this background, let’s now consider the question of criminal liability, as well as the feasibility of prosecution.
A REASONABLE LIST of prosecutable crimes committed during the bubble, the crisis, and the aftermath period by financial services firms includes:
• Securities fraud (many forms)
• Accounting fraud (many forms)
• Honest services violations (mail fraud statute)
• Bribery
• Perjury and making false statements to federal investigators
• Sarbanes-Oxley violations (certifying false accounting statements)
• RICO offenses and criminal antitrust violations
• Federal aid disclosure regulations (related to Federal Reserve loans)
• Personal conduct offenses (many forms: drug use, tax evasion, etc.)
In addition, financial sector firms and executives committed many civil offenses for which they could be pursued in civil actions, which have a lower burden of proof (preponderance of evidence, as opposed to beyond a reasonable doubt). These offenses include civil Sarbanes-Oxley violations, civil fraud, and violations of multiple SEC regulations, particularly regulations related to disclosure requirements.
Let’s consider some examples.
Here, we face an embarrassment of riches. The primary applicable authority is Rule 10b-5, promulgated by the SEC under the authority of the 1934 Securities Exchange Act. It reads:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
There are several essential elements to a 10b-5 offense: it must be a misstatement or omission that is sufficiently material to affect an investor’s opinion; that is made intentionally; that the investor relied upon in making his decision; and that directly caused actual losses. The rule can be used by the SEC for bringing civil cases, by the Justice Department for both civil and criminal actions, and also by private parties bringing civil suits. Even if the securities in question are being sold to sophisticated, professional investors, you can’t lie to them.
Where to begin?
As we have already seen, almost all the prospectuses and sales material on mortgage-backed bonds sold from 2005 through 2007 were a compound of falsehoods. But it starts even earlier in the food chain. We have also already seen that mortgage originators committed securities fraud when they misrepresented the characteristics of loan pools, and the nature and extent of their due diligence with regard to them, when they sold pools to securitizers (and accepted financing from them). Most or all of the securitizers (meaning nearly all the investment banks and major banking conglomerates) then committed securities fraud when they misrepresented the characteristics of loans backing their CDOs, the characteristics of the resulting mortgage-backed securities, and the nature and results of their due diligence in the process of creating those CDOs. The securitizers also committed securities fraud when they made similar misrepresentations to the insurers of, and sellers of CDS protection on, those CDOs.
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 arm had been dragooned into finding and dumping their most dangerous 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 lies, and they were material lies, since investors had learned to be wary of banks clearing out their own bad inventory. Email trails show that top executives closely tracked the garbage disposals and were gleeful at the unloading of the Timberwolf assets—as they should have been, for the assets were nearly worthless within months. There have been no prosecutions.
Many large U.S. 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 defense—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 already have clear evidence of senior executive knowledge of and involvement in these frauds. 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 other cases, such as Bear Stearns, we already have evidence from civil lawsuits that very senior executives were directly involved in constructing and selling securities whose prospectuses contained lies and omissions. In other cases, we do not yet have direct evidence of senior executive involvement, but such involvement is likely. 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 already know, of course, that both Fannie Mae and Freddie Mac 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 offenses has now expired.
However, we also know of other major probable violations. The best known is the “Repo 105” trick by which Lehman Brothers, with the knowledge of its U.S. accounting firm, fraudulently concealed its real level of leverage during the bubble. Lehman’s American accountants, Ernst & Young, shielded themselves by insisting that Repo 105 deals be nominally run through an international subsidiary, so they could pretend not to notice when they produced the consolidated numbers. Despite the fact that this was clearly a sham transaction, nobody has been prosecuted or even fined.
Lehman and many other securitizers also inflated the value of their assets. In Lehman’s case, the most egregious overvaluation was in its commercial real estate 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 is 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 inconceivable 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 U.S. accounting firm related to the bubble.
The 1988 amendments to the federal 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. In addition, the Jefferson County case involves, first, bribes paid by JPMorgan Chase to county officials but, even more interestingly, bribes paid 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 first amendment free speech defense 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 corrupt services to investors. They slanted their ratings to favor issuers who paid them; they failed to disclose the extent to which they were paid consulting fees by those issuers; they failed to disclose that senior management was pressuring employees to rate unreasonably large numbers of securities, precluding any effective due diligence; they failed to disclose that when offered information (for example by Clayton Holdings) that would have improved the accuracy of ratings, they deliberately refused the information; and they represented that they were actually providing unbiased ratings services when, often, they were simply providing assembly-line high ratings for fraudulent securities. There has not been a single criminal prosecution, either for honest services violations or any other offense, 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 Congress. It is also a felony to lie to federal investigators.
Here, there are many opportunities. Many cases might be difficult to prove, but the blunt reality is that many financial executives lied 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 clearly 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 bluntly, beyond absurd. When Mr. Blankfein so testified, he was, in my opinion, perjuring himself. Now, could they prove it? I’m willing to bet that if you go through his e-mail carefully and depose everyone around him, there would be plenty of evidence that he knew perfectly well how important ratings are. His testimony before Senator Levin’s committee was also highly suspect 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 afterward too.
To take another example, this time from the hearings of the Financial Crisis Inquiry Commission (and yes, that was sworn testimony), here is former Citigroup CEO Chuck Prince in an exchange with a commission member questioning him and Robert Rubin:36
EXAMINATION BY COMMISSIONER MURREN
COMMISSIONER MURREN: You mentioned capital requirements are very important. Did Citigroup ever create products that were specifically designed to avoid capital requirements?
MR. RUBÍN: I don’t know the answer to that.
COMMISSIONER MURREN: And you, Mr. Prince, would you create a product simply to—or at least one of the principal reasons for designing the product was to avoid capital requirements?
MR. PRINCE: I—I think the answer is no because the product would have to be designed as something that a client would want. In other words, you wouldn’t create a product that was internally focused. If your question is, would the—would the team create products—and in the course of creating the products, try to minimize capital burdens, my guess is the answer is yes, but I don’t know for sure.
COMMISSIONER MURREN: So then it wouldn’t surprise you to know that in the minutes of one of your meetings that specifically relate to the creation of new products, in this instance, it would be liquidity puts, that there was a notation that specifically referenced the fact that this type of structure would avoid capital requirements?
MR. PRINCE: I have no way of responding without seeing the document and understanding the context of it.
“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.
One could provide many further examples of this kind.
The congressional hearings produced not only widespread revulsion but a clear, widely shared sense that there was an awful lot of lying going on. There have been no prosecutions for perjury.
The Sarbanes-Oxley Act establishes a variety of requirements for CEO and senior management conduct and also establishes criminal penalties for certain violations. CEOs and CFOs of public companies are required to certify their companies’ financial statements and tax returns, and also to certify the adequacy of the firms’ internal controls for accurate financial reporting. The SEC is responsible for establishing regulations in these areas and can pursue civil cases for violating them. But the law also provides for criminal penalties, including up to ten years in federal prison, for knowingly certifying inaccurate financial statements, destroying records, or retaliating against a whistle-blower for contacting law enforcement authorities.
We have already seen the level of misrepresentation in loan portfolios, prospectuses, investor presentations, and so forth. We have seen the inadequacy of internal due diligence and frequently the deliberate suppression of such due diligence, with regard to loan quality, and also with regard to how nonconforming loans were handled—many were securitized in conscious violation of internal guidelines. Does this bespeak adequate internal financial controls? We also know, of course, that both lenders and securitizers were wildly inaccurate in their valuations of loans, of CDOs, and of their own financial positions. How much of this was known to their CEOs? The answer cannot be none. Indeed, we already have considerable public evidence that suggests the contrary.
Consider Citigroup. One day after Richard Bowen sent his e-mail to four senior Citigroup executives including its CFO and vice-chairman Robert Rubin, Citigroup’s then-CEO Chuck Prince signed the firm’s Sarbanes-Oxley certification. Three months later, after Prince was replaced by Vikram Pandit, the Office of the Comptroller of the Currency sent a letter, addressed to Pandit personally, explicitly warning him of major deficiencies in Citigroup’s financial reporting and controls. Eight days later, Pandit signed his first Sarbanes-Oxley certification for Citigroup. Over the subsequent two years, Citigroup lost billions of dollars more as its earlier securities valuations proved inaccurate.
Or consider AIG. What do we think of AIG’s financial controls in late 2007 and 2008, particularly after AIGFP’s internal auditor resigned in protest after warning AIG’s chief auditor that he was being blocked from doing his job? And what do we think of Richard Fuld and his CFO, Erin Callan, signing off on Lehman Brothers’ accounting statements in 2008?
Indeed, Lehman provides particularly direct evidence, not only through disclosure of the Repo 105 accounting trick, but also through the actions of an internal whistle-blower. Matthew Lee was Lehman’s senior vice president with responsibility for overseeing the firm’s global balance sheet. On May 16, 2008, Mr. Lee delivered a letter by hand to four Lehman executives: Martin Kelley, Lehman’s controller; Gerald Reilly, head of capital markets product control; Christopher O’Meara, chief risk officer; and Erin Callan, the CFO.37 Lee begins his letter by noting that he had worked for Lehman since 1994, and had been a “loyal and dedicated employee.” He then continues:
I have become aware of certain conduct and practices, however, that I feel compelled to bring to your attention …
I have reason to believe that certain conduct on the part of senior management of the firm may be in violation of the [Lehman] Code [of Ethics]. The following is a summary …
1. On the last day of each month, the books and records of the firm contain approximately five (5) billion dollars in assets in excess of what is managed … I believe this pattern indicates that the Firm’s senior management is not in sufficient control of its assets to be able to establish that its financial statements are presented to the public and governmental agencies in a “fair, accurate, and timely manner.” … I believe … there could be approximately five (5) billion dollars of assets subject to a potential write-off … at the minimum, I believe the manner in which the firm is reporting these assets is potentially misleading to the public and various governmental agencies.…
2. The Firm has an established practice of substantiating each balance sheet account … The Firm has tens of billions of dollars of unsubstantiated balances, which may or may not be “bad” or non-performing assets or real liabilities. In any event, the Firm’s senior management may not be in a position to know whether all of these accounts are, in fact, described in a “fair, accurate, and timely” manner, as required by the Code …
3. The Firm has tens of billions of dollar [sic] of inventory that it probably cannot buy or sell in any recognized market, at the currently recorded market values …
4. I do not believe the Firm has invested sufficiently in the required and reasonably necessary financial systems and personnel to cope with this increased balance sheet …
5. I do not believe there is sufficient knowledgeable management in place in the Mumbai, India finance functions and department. There is a very real possibility of a potential misstatement of material facts …
6. Finally, … certain senior level internal audit personnel do not have the professional expertise to properly exercise the audit functions they are entrusted to manage …
I would be happy to discuss regarding the foregoing with senior management but I felt compelled, both morally and legally, to bring these issues to your attention …
For the most part, Lee turned out to be right. About a month later, Lee also warned Lehman’s auditors, Ernst & Young, about the Repo 105 trick. (But that wasn’t necessary; they had already known about it, and done nothing to stop it, for over a year.38 They haven’t been prosecuted either.) So, what do we think of Erin Callan and Richard Fuld certifying Lehman’s financial statements for that quarter?
Or how about Angelo Mozilo’s certifications of Countrywide’s statements and the adequacy of its internal financial controls? Or Stan O’Neal’s signing off on Merrill Lynch’s statements, while his employees were bribing each other, and the firm’s profits turned to $80 billion in losses in the two years after he departed? Et cetera. Yet there have been no civil or criminal cases filed based on Sarbanes-Oxley violations.
Both RICO and federal antitrust laws provide tools for prosecuting criminal conspiracies. The Racketeer Influenced and Corrupt Organizations Act (RICO) provides for severe criminal (and civil) penalties for operating a criminal organization. It specifically enables prosecution of the leaders of a criminal organization for having ordered or assisted others to commit crimes. It also provides that racketeers must forfeit all ill-gotten gains obtained through a pattern of criminal activity, and allows federal prosecutors to obtain pre-trial restraining orders to seize defendants’ assets. And finally, it provides for criminal prosecution of corporations that employ RICO offenders.
RICO was explicitly intended to cover organized financial crime as well as violent criminal organizations such as the Mafia and drug cartels. Indeed, the law professor who drafted much of the legislation, G. Robert Blakey, once told Time magazine that “we don’t want one set of rules for people whose collars are blue or whose names end in vowels, and another set for those whose collars are white and have Ivy League diplomas.” The RICO statute has been used in cases ranging from the sex-abuse scandals of the Catholic Church to Michael Milken. Indeed the criminal cases brought against both Milken and his firm, Drexel Burnham Lambert, were based on the RICO statute. A great deal of the behavior that occurred during the bubble, covered in this and previous chapters, would appear to fall under RICO statutes. Moreover, pre-trial asset seizure is a widely and successfully used technique in combating organized crime, and federal asset seizures now generate over $1 billion per year. However, there has not been a single RICO prosecution related to the financial crisis, nor has a single RICO restraining order been issued to seize the assets of either any individual banker or any firm.
It is important to note here that federal asset seizures would not merely represent justice for offenders, but for victims as well. Federal law allows seized assets to be used to compensate victims. In this case, the potential economic impact of seizures could be enormous. Seizing the personal assets of just seven people bearing enormous responsibility for the bubble and crisis (Angelo Mozilo, Richard Fuld, Jimmy Cayne, Joseph Cassano, Stan O’Neal, Henry Paulson, and Lloyd Blankfein) could provide over $2 billion to compensate victims. If the federal government were to seize assets from, say, five thousand people representing a substantial fraction of total investment banking bonuses (and criminal behavior) related to the bubble, this would potentially generate tens of billions of dollars in victim compensation. Such actions would probably provide more victim compensation than the entire $26 billion settlement of the foreclosure fraud lawsuits brought by 49 state attorneys general.
Antitrust law provides another tool for both criminal prosecution and extraction of financial restitution. Since 1975, federal antitrust law has provided for severe criminal penalties for antitrust violations. Antitrust law also provides for treble damages in civil judgments, which can be based upon evidence from criminal convictions.
There is ample reason to suspect that collusion and antitrust violations are common within the financial industry. Several prominent observers of the industry—including Simon Johnson, Eliot Spitzer, and financial journalist William Cohan—have suggested that American banking deserves serious examination for antitrust problems. One major antitrust investigation, under way as of this writing and being conducted by U.S., European, and Japanese regulators and prosecutors, is focused on price-fixing of interest rates, particularly the London Interbank Offered Rate (LIBOR), the interbank lending rate used to set many short-term interest rates. There have also been a series of civil settlements, described above, related to price-fixing and bid-rigging in the municipal bond market.
More generally the industry has become extremely concentrated, and all the major firms do business with each other, even in markets in which they supposedly compete. The overwhelming majority of all U.S. securities underwriting, private equity financing, merger and acquisition transactions, and derivatives trading is now controlled by Goldman Sachs, JPMorgan Chase, Morgan Stanley, Citigroup, Bank of America, and Wells Fargo. The largest private equity firms (such as KKR, Blackstone, and the Texas Pacific Group) often cooperatively bid for companies, and work not only with each other but with major banks in constructing financing packages for leveraged buyouts.
All the major banks charge the same fees for major services such as underwriting initial public offerings (7 percent), junk bonds (3 percent), or loan syndications (1 percent).39 Moreover, both stock and bond offerings are often “syndicated.” In this case, whichever bank wins the business of underwriting a given offering subcontracts portions of the offering to its supposed competitors. The banks also have created and operate a number of joint ventures, including two, MERS and Markit, that were heavily involved in the financial bubble and crisis.
By sheerest coincidence, the client agreements used for brokerage accounts by the major banks all contain identical provisions, by which all clients give up the right to use the courts to sue their brokerage for fraud. Rather, clients must use arbitration proceedings controlled by FINRA, the industry’s generally spineless self-regulatory body. This arbitration provision is not intended to improve efficiency; on the contrary, FINRA arbitrations are protracted and extremely expensive, requiring high legal fees and payments to arbitrators. Rather, the industry’s motivation is that FINRA arbitrations tend to favor the industry, and, importantly, they are secret, as opposed to court cases in which embarrassing information could be made public. How all the banks spontaneously decided to use the same brokerage contract terms has not been explained.
The banks, together with Visa and Mastercard, also seem to have arrived at identical conclusions in setting “interchange fees” for processing credit card transactions. Interchange fees in Europe and Australia are generally 0.6 percent of transaction value or less; U.S. interchange fees are uniformly 2 percent. In September 2005, a large coalition of retail industry associations filed a class-action antitrust lawsuit against Visa, Mastercard, and America’s thirteen largest banks.40 As of early 2012, the case is still pending. Potential damages estimates have ranged from several billion to tens of billions of dollars. However, the federal antitrust authorities have taken no action.
Indeed, despite this pattern of widespread industry collusion, there has not been a significant criminal antitrust conviction of any major bank, or any individual banker, in the United States in the last thirty years.
On November 27, 2011, Bloomberg News reported that as a result of its Freedom of Information Act filings, it had learned that during the crisis, Federal Reserve Board loan assistance to the largest banks had been far larger than previously believed. The Fed had kept the information secret; previous estimates based on then-available documents had set the total amount of assistance at $2 trillion to $3 trillion. Upon obtaining the documents, Bloomberg found that the actual amount, including loans, loan guarantees, securities purchases, and other commitments, was a rather amazing $7.8 trillion, with several hundred billion dollars in loans outstanding at any given time during the height of the crisis.41 Bloomberg estimated that these low-interest loans generated $13 billion in additional profits for the banks; one of my colleagues believes that the banks’ profits were probably far larger.
Since 1989, SEC regulations have required public companies to disclose material federal assistance. None of the banks disclosed the size of these loans or their impact on profits.42 This is a civil, not a criminal, offense. But at the same time that the banks were so heavily dependent upon massive government support, several of them claimed that their financial positions were secure. This could be interpreted as a securities fraud violation. There have been no related SEC civil cases filed or criminal prosecutions.
Personal conduct subject to criminal prosecution might range from possession and use of drugs, such as marijuana and cocaine, to hiring of prostitutes, employment of prostitutes for business purposes, fraudulent billing of personal or illegal services as business expenses (sexual services, strip club patronage, and nightclub patronage), fraudulent use or misappropriation of corporate assets or services for personal use (e.g., use of corporate jets), personal tax evasion, and a variety of other offenses.
I should perhaps make clear here that I’m not enthusiastic about prosecuting people for possession or use of marijuana, which I think should be legal. In general, I tend to think that anything done by two healthy consenting adults, including sex for pay, should be legal too. I’m ambivalent about cocaine, which does seem to be destructive, although its criminalization is hugely destructive too. My general point is simply that, in ordinary circumstances, I would not advocate expending law enforcement resources in this area.
But the circumstances here are not ordinary. First, there is once again a vast disparity between the treatment of ordinary people and investment bankers. Every year, about fifty thousand people are arrested in New York City for possession of marijuana—most of them ordinary people, not criminals, whose only offense was to accidentally end up within the orbit of a police officer. Not a single one of them is ever named Jimmy Cayne, despite the fact that his marijuana habit has been discussed multiple times in the national media. Everyone in New York knows that investment banking is probably the largest cocaine market on the planet, not to mention a pillar of the strip club and escort industries. Who did the Feds bag for hiring escorts? Eliot Spitzer.
There is also a second, even more serious, point about this. If the supposed reason for failure to prosecute is the difficulty of making cases, then there is an awfully easy way to get a lot of bankers to talk. It is a technique used routinely in organized crime cases. What is this, if not organized crime?
As time passes, criminal prosecution of bubble-era frauds will become even more difficult, even impossible, because the statute of limitations for many of these crimes is short—three to five years. So an immense opportunity for both justice and public education will soon be lost. In some circumstances, cases can be opened or reopened after the statute of limitations has expired, if new evidence appears; but finding new evidence will grow more difficult with time as well. And there is no sign whatsoever that the Obama administration is interested.
But enough about criminality. Let’s turn to large-scale economic waste and destabilization—because deregulated modern banking is good at that, too.
* Swap agreements almost always include breakup fees calculated as the present value of the net stream of income due to the aggrieved party over the remaining life of the deal.
* Merrill, for example, offered investors the opportunity to recover four times the return on referenced Madoff funds. An investor would put up, say, $1 million, and receive a Merrill note in exchange, plus a top-up loan of $3 million. In return, Merrill received an investment fee, plus a hefty lending fee. To cover its liability, Merrill then would typically invest the $4 million into the referenced Madoff fund—although it was not required to do so. Each month, it paid the amount of dividends the customer would have received if he or she had a $4 million Madoff account, less a 20 percent incentive fee. Note that Merrill itself did not have to take any investment risk, and that customer funds were never directly invested in a Madoff account.
* The original account was opened in 1986 with Chemical Bank, which later merged with Chase. The Chase/JPMorgan merger was in 2001, when Madoff was on the verge of spectacular growth.