IN MID-MARCH 2010, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a twenty-two-hundred-page report about the demise of the firm. The report, which included eye-opening details about Lehman’s accounting practices, put in sharp relief what we, and many others, had suspected all along: that fraud and potentially criminal conduct were at the heart of the financial crisis. This was the first case where we were able to see the facts as developed by a competent and independent fact-finder, unlike the shrouded investigations under way at the Justice Department and SEC (even in our private meetings with the Justice Department, FBI, and SEC, we still hadn’t learned any details about specific cases).
The bankruptcy examiner’s report was devastatingly unequivocal. It stated clearly that Lehman had cooked its books, hiding $50 billion in toxic assets by temporarily shifting them off its balance sheet in time to produce rosier quarterly reports. The bankruptcy examiner called Lehman’s financial statements “materially misleading” and said its executives had engaged in “actionable balance sheet manipulation.”
Lehman Brothers may have gone under, but the people responsible for this fraud are still around. Why aren’t these people being prosecuted and, if found guilty by a jury, going to jail?
After the release of the bankruptcy report, I worked all weekend on a speech for Ted entitled “Restoring the Rule of Law to Wall Street.” On Monday, Geoff and Jane Woodfin, Ted’s legislative director, helped me polish it. The next day, Ted was the first on the Senate floor to speak. He blasted Lehman, Wall Street’s Wild West attitude, the colossal failures of accountants and lawyers who misunderstood or disregarded their role as gatekeepers, and the inaction of government prosecutors. “We must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street. We must treat financial crimes with the same gravity as other crimes, because the price of inaction and a failure to deter future misconduct is enormous.”
One unexpected benefit of Scott Brown’s election to the Senate in early 2010 to fill Ted Kennedy’s seat was that it opened a Democratic seat, which Ted filled, on the Permanent Subcommittee on Investigations (PSI), which Senator Carl Levin (D-MI) chairs. The PSI has subpoena power and a broad mandate, wielded by its Chairman, to investigate corruption. Levin and his staff had been investigating the financial crisis for more than a year, and he’d decided to accelerate the dates for a series of hearings on Washington Mutual (WaMu), the Office of Thrift Supervision (OTS), credit-rating agencies, and Goldman Sachs. The hearings would illuminate the chain of wrongdoing from the mortgage-origination level, to the failure of bank regulators and credit-rating agencies, to the securitization and packaging of subprime mortgages by Wall Street banks.
The first three hearings (on WaMu, OTS, and the credit-rating agencies) received far less attention than the final hearing on Goldman Sachs, but they were devastating. Evidence gathered by the subcommittee demonstrated that WaMu executives tolerated, and possibly encouraged, widespread fraud as part of an effort to dramatically expand loan volume. Approximately 90 percent of WaMu’s home equity loans were so-called “stated income” loans (known more glibly and more accurately as “liar’s loans”), which allowed borrowers to state their income on the loan application without providing any supporting documentation. As Treasury Department Inspector General Eric Thorson said at the hearing, WaMu’s high percentage of stated income loans created a “target rich environment” for fraud.
An internal review of a WaMu loan office in Southern California revealed that 83 percent of its loans contained instances of confirmed fraud; in another office, the figure was 58 percent. And what did WaMu management do when it became clear that fraud rates were rising as housing prices began to fall? Rather than curb its reckless practices, it decided to try to sell a higher proportion of these risky, fraud-tainted mortgages into the secondary market, thereby locking in a profit for itself as it spread the contagion into the capital markets.
The second hearing showed that OTS had failed abjectly to regulate WaMu and to protect the public from the consequences of WaMu’s excessive risk-taking and toleration of widespread fraud. Although WaMu accounted for 25 percent of OTS’s regulatory portfolio, OTS adopted a laissez-faire approach. OTS’s front-line bank examiners had identified the high prevalence of fraud and weak internal controls at WaMu, yet the OTS leadership did virtually nothing to address the situation. In fact, OTS advocated for WaMu with other regulators and, in 2007 and 2008, had actively thwarted an investigation of WaMu by the Federal Deposit Insurance Corporation (FDIC). The explanation for OTS’s complete abdication of regulatory responsibility may be that it was dependent on WaMu’s user fees for 12–15 percent of its budget. The hearing exposed the spectacle of a regulator competing for business (WaMu and other banks could choose whether its primary regulator would be OTS or the FDIC) by currying favor with the very entity it was supposed to regulate, just so it wouldn’t lose the revenue stream to another regulator. This was more than the perhaps inevitable coziness that comes from long interaction. This was a system structured to make regulatory capture inevitable.
At the hearings, Treasury Inspector General Thorson said he didn’t know whether regulators’ hesitation to take any action was “because they get too close [to the banks] after so many years or [because] they’re just hesitant or maybe the amount of fees enters into it. . . . But whatever it is, this is not unique to WaMu and it is not unique to OTS.”
After the hearings, Ted went to the Senate floor and praised Levin’s work, comparing it to the Pecora Commission of the 1930s, which had galvanized Congress to pass major Depression-era reforms. As for Ted and me, we were both becoming convinced that there was fraud for the government to prosecute.
Where were the Justice Department and the SEC? Two thorough investigations—Lehman by the bankruptcy examiner, WaMu by the PSI—had uncovered what certainly looked like fraud. The PSI and bankruptcy-examiner reports were strong indications that when competent, motivated, and well-led investigators look at what took place in the financial crisis, they find evidence of fraud. With no indication that the prosecution of either fraud was imminent, Ted and I were now deeply concerned.
Why weren’t we seeing any cases? There were at least three possibilities. First, it was too soon. The investigation of complex financial fraud is a long process; in time, the cases would come (as it turns out, they never did). Second, there was no provable criminal conduct. The Justice Department and the SEC had turned over every rock, considered every piece of evidence, and concluded that mass delusion, not fraud, had caused the crisis. In light of the Lehman bankruptcy report and the PSI hearings (and the absence of real commitment by the Justice Department), that possibility was easy to dismiss. Third, the failure of the government to take a timely, targeted, all-in approach to the problem had condemned it to failure. When investigating complex fraud perpetrated by sophisticated, well-advised actors able to bury disclosures in mountains of paper, anything less than timely and full commitment won’t be enough. Increasingly, it looked like this third possibility was the sad answer to our question.