More prosecutions of investment banks coming?

By Felix Salmon
September 27, 2010
Gretchen Morgenson buried something explosive in her story today about the FCIC testimony of a mortgage-analysis executive in Sacramento?

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Has Gretchen Morgenson buried something explosive in her story today about the FCIC testimony of a mortgage-analysis executive in Sacramento? Here’s her 28th and 29th paragraphs:

Because these loan samples were provided to the Wall Street investment banks that commissioned them, they could see throughout 2006 and into 2007 that the mortgages they were financing and selling to investors were becoming increasingly sketchy.

The results of the Clayton analyses were not disclosed to investors buying the loan pools. Instead, Wall Street firms used the information to pressure the lenders issuing the most troubled loans to accept a lower price for them, according to prosecutors who have investigated these cases.

If you remember, the SEC’s central accusation against Goldman Sachs was that it lied to its clients — it knew something important about the Abacus deal which the clients didn’t know, and Goldman didn’t see fit to enlighten them.

That case, centered on one deal at one bank, resulted in a $550 million fine, and billions of dollars of market capitalization wiped off Goldman’s share price.

Yet it seems here that something similar was going on very regularly, not only at Goldman but also at Citigroup, Deutsche Bank, UBS, Merrill Lynch, Bear Stearns and Morgan Stanley.

This time, the lie of omission was not that John Paulson was both choosing and shorting the CDS in a synthetic CDO. Rather, it was that Clayton Holdings had analyzed the mortgages going into subprime mortgage pools, and found that only 54% of the loans going in to subprime mortgage pools met the lenders’ underwriting standards, and that 28% of the loans sampled were outright failures. Many of those failures ended up being accepted into the pools, rather than rejected.

Obviously, the numbers varied from bank to bank. (Goldman’s almost endearing in its doomed attempted defense that “the percentage of deficient loans that went into its pools was smaller than Clayton’s average”.) But it seems here that the banks knew that their loan pools were dirty — they told as much to the originators, and tried to to get a discount on the loans as a result. But they didn’t bother to inform the investors in those pools.

In fact, the banks might even have had an incentive to put together dirty pools. After all, dirty loans come cheaper — and so you can make more money when you sell them off to bond investors at the same price as cleaner loans.

If prosecutors are chatting away to Morgenson about this, I suspect that indictments are coming down the pike. And given how important the SEC’s case against Goldman turned out to be, a series of big cases against a whole slew of investment banks could have enormous repercussions for their reputation and their share prices. So beware, anybody buying stock in Goldman, Citi, BofA or Morgan Stanley: there’s serious litigation risk here, I think.


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Well said, Felix. Clearly the fix was in by 06-07 ON WALL STREET, not Main St.

Why is this distinction so important? Because Americans are still playing a sordid game of “kick thy neighbor,” with renters and long-time homeowners blaming “greedy” or “stupid” bubble buyers for being stuck with underwater property. From long-time owners (largely pre-2000 by now) there is much tut-tutting but little understanding for the suffering of neighbors who bought later. From younger would-be buyers/renters there is cold-blooded vengeance mixed with a sense of frustration that homeowners are not jumping off the rooftops faster and banks are not selling to them at rock-bottom prices (yet).

I have been saying for years now that the water was poisoned upriver, but we are blaming the people who drank downstream and got sick. This is perverse and counterproductive.

If we can get some prosecutions out of this and get people to understand how much they have lost as a nation, and how much they have been manipulated, then we may actually start pulling together to solve the problem.

Posted by LadyGodiva | Report as abusive

There are two excuses for the housing mess:
A. Bankers were soooo stupid that they did not know that loans had to be repaid
B. they did not know because when making millions upon millions depends on not knowing the quality of a loan, they put quite a bit of effort into not knowing.

If the US Justice department was too stupid too figure this out 2 years ago, why do you think they now know?
Us Gubermint policy is obviously that first and formost, banks must be saved at all costs, and the bigger and stupidier the bag, the more the bailout

Posted by fresnodan | Report as abusive

There was bad behavior all around. I have a friend who bragged to me about the job and income he fabricated for himself for the inappropriately large house he bought in the middle of the last decade.

He ended up selling the house massively short and sticking his bank with an enormous loss. Did he commit a crime? Certainly. Will he face prosecution? Not a chance. He is a victim.

Posted by DanHess | Report as abusive

I do not fathom any seriously legitimate litigation might ever arise from this. Pay some fines, well-meaning restitution and move ahead.

The banks had no true reason to stop. Only if/when investors in the lowest-rated (BB, BBB) dreck stopped buying, would the issuance volume screech to an end. Hey, nothing beats hosing those institutional, buy-side customers. Such fools.

Posted by McGriffen | Report as abusive

I can’t wait til we get to the part where the Senate parades some more evil Wall Street execs out and says mean things to them and gives them dirty looks. That is so intense!

Posted by Woltmann | Report as abusive

Bad behaviour all round indeed, Dan. The sound of hand slapping is deafening!

I sincerely hope they start looking at the top and realizing it was larger then a few bad mortgage brokers.

Felix, when Goldman said on April 20 “but, everybody was doing it…” they meant it!

Posted by hsvkitty | Report as abusive

Of course the flaw in the story is the assumption that Gretchen is accurately and competently reporting the facts…. Now I know past performance is not a guide to future performance but I wouldn’t be taking this as a slam dunk.

Anyway Obama got his bill passed so there is no more need to villify bankers, he can just keep this in his pocket for next time he needs to people to look the other way.

Posted by Danny_Black | Report as abusive

DanHess, amen. Weird how the people who actually did commit fraud are now victims….

Posted by Danny_Black | Report as abusive