When the boom turns to a bust, throughout modern history, politicians begin to prosecute financiers. This prosecution always brings with it new rules, new regulations and it fundamentally changes how financial markets work in future. While this is an American story, non-American readers should understand that this tale has implications for them. Just as Sarbanes-Oxley has permeated the regulatory environment around the world, so will the outcome of the current financial crisis. Our story merely begins in America. It ends on your doorstep.
Historically, the Shakesperian tragedy plays out for financial markets each cycle.
After the boom turns a bust, we usually find that there are innocent victims who politicians seek to protect from the avarice of Wall Street. After the dot.com bubble burst the market experienced September 11th and seven of the nine largest bankruptcies in American history in a twelve month period. Politicians responded by seeking to contain and prosecute those who had reaped losses on the innocent public. At the time, Elliot Spitzer was the New York State Prosecutor. He put on his sheriff’s badge (The Sheriff became his nickname) and went about prosecuting Wall Street. The Justice Department did the same. Together they managed to convict Arthur Anderson, Ken Lay, the former CEO of Enron and many other CEOs as well as a bunch of analysts on Wall Street.
These convictions launched Spitzer on the path to the Governorship of New York. There is little doubt that he believed he was on the path to the White House until other more base motives intervened recently.
The previous big financial crisis (in the US – few prosecution options were available in the Asian financial crisis) was the Savings and Loan Crisis. At that time, the New York State Prosecutor was Rudy Gulliani. The S&Ls had taken on enough risk to bankrupt virtually each individual S&L, therefore the whole industry. Many innocent victims emerged at that time. The S&L debacle gave rise to a credit crunch and a property collapse and a general recession. Rudy Gulliani realized that the S&Ls would never have been able to leverage up their risk without the help of the high yield bond market which was fathered by Mike Milken. As the poster boy of leveraged risk, he became Gulliani’s target. When Gulliani got his man it launched him on the road to the Mayorship of New York. There is little doubt that he believed he was on the path to the White House until recently. But, in a twist of irony, he now seems to be on the path to the Governorship of New York, which Governor Spitzer has recently vacated.
The story has many iterations over history but we should not forget Ferdinand Pecora. He was the New York State prosecutor after the crash of 1929. In the famous Pecora
Commission hearings, he managed to haul up everyone on Wall Street to his hearings including JP Morgan himself. While few actually went to jail, it is widely acknowledged that just getting JP Morgan physically into the witness stand and then succeeding at grilling him for many hours amounted to “getting his man”. Pecora was on the cover of Time magazine in 1933. There is little doubt that he believed he was on the path to at least the Mayorship of New York, if not the White House until he actually ran for the Mayorial election and lost.
So, this time, it is not too hard to see how the pattern plays out. Andrew Cuomo, the current person in the New York prosecutor’s role, is widely considered to be the most promising Democrat of his generation (other than Senator Obama). Many expect him to vie for the Presidency one day. For him, the current financial landscape presents an easy shot at a home run. The big banks and brokerages took on more risk than their capital base prudently allowed and managed to deprive millions of the lowest income Americans of not only their homes, but also of the very American dream of homeownership now that mortgages cannot be had at any price. That deserves prosecution. The New York State Attorney has issued subpoenas against all of the Federal Reserve regulated banks (fourteen of them). In addition, some of the mortgage originators, like Clayton Holdings, have agreed to become witnesses for the prosecution against firms like Goldman Sachs in exchange for immunity. The FBI is now formally investigating fourteen companies they believe to have been engaged with mortgage fraud.
The litany of allegations is becoming longer everyday: insider trading, mis-selling, conflicts of interest, front-running and the list goes on. These are not just random lawsuits. The results of these lawsuits will form the basis for the financial rules going forward. For example, consider the government entities that have lost money on sub-prime, collateralised debt obligations and asset backed securities. The board can say, “well, we made a bad investment decision”. This results in having the board resign. Or, the board can say, “those lousy bankers sold us a crock and never properly explained the risks.” In this case the banker is held accountable, not the board. The banker then pays a settlement or pays out in case of a judgement. Most juries are going to go with the grandmothers (and their representatives on pension boards and government boards) on this.
Recently the local government of Springfield Massachusetts brought a mis-selling case against Merrill Lynch. Merrill settled and paid all the legal fees for Springfield and damages. Within an hour of the settlement being announced, Massachussetts’ state secretary announced a new investigation into Merrill in conjunction with the SEC on securities fraud charges. Once there is blood and money in the water, there is no stopping the lawsuits.