This post is adapted from a speech delivered Nov. 2, 2010, to more than 300 financial regulators and Wall Street executives during a panel discussion entitled "Financial Crisis and Financial Crimes" at the Federal Reserve Bank of New York.
I'm going to address briefly four questions, all of which go to the integrity and competitiveness of our capital markets.
First, was there fraud at the heart of the financial crisis?
Second, has the law enforcement response so far achieved effective levels of deterrence against financial fraud?
Third, are federal law enforcement agencies sufficiently capable of detecting fraud and manipulation, particularly in markets that are increasingly complex?
And finally, should Wall Street itself care about all this?
In short, my answers would be yes, no, no and yes.
But I think it would be a mistake to view the financial crisis and government's response as partisan issues.
Indeed, on June 3, in the midst of the Senate debate on the Dodd bill, I picked up my Wall Street Journal and read the following:
"The left says Congress is counting too much on the wisdom of discredited regulators. 'We should follow in the footsteps of our forbears from the 1930s who made the tough decisions and wrote bright-line laws which lasted for over 60 years--until they were repealed,'" said Sen. Ted Kaufman (D., Del.).
"The right counters with an attack on big government. Sen. Richard Shelby (R., Ala.) blasts the new consumer-finance regulator as 'the Democrats' new bureaucracy' and 'a massive expansion of government influence in our daily financial lives.'"
I called the columnist and said politely: There's only one flaw with your thesis: Senator Shelby voted FOR the Brown-Kaufman amendment to limit bank size and leverage! Why are we the "left" and he is the "right"... when on the major issue of "Too Big to Fail" we came out at the same place? To me, it is a conservative view to want to go back to what had worked in the past. Senator Kaufman wanted short bills that draw hard statutory lines, that firmly resolve inherent conflicts of interest, and that give regulators clear guidance.
Now, to Question 1: Was there fraud at the heart of the financial crisis? On this question, the left and right clearly came together during the 111th Congress. Co-authored by Senate Judiciary Committee Chairman Pat Leahy, Senator Chuck Grassley and Sen Kaufman, the Fraud Enforcement Recovery Act -- or FERA, as it is known -- received 92 votes on the Senate floor and was signed into law by President Obama in May 2009. FERA authorized an additional $165 million in resources to federal investigators and prosecutors to target fraud connected to the financial crisis.
From the beginning we recognized there was a wide spectrum of behavior: from those banks that never even issued sub-prime mortgages, to those who perhaps recklessly but not criminally assumed housing pricings would never fall -- to those who had actual knowledge that they were engaged in fraudulent behavior, lined their own pockets, failed to disclose material information and left investors holding the bag.
Even if there were only a few bad apples, well-trained law enforcement officials needed additional resources to sort through the mountain of actors, transactions and evidence, and FERA was designed to give it to them.
The counter-narrative is that all information about the underlying mortgages was disclosed, even if buried deep in the documents; that the markets themselves were not distinguishing among the quality of the underlying mortgage pools, pricing all mortgage-backed securities on the basis of the evaluations stamped on them by the credit rating agencies; that buyers were not performing due diligence; and therefore any fraud that might have occurred was isolated and played a minor role.
There may be some truth to this counter-narrative, at least in part because the disclosures that were made can make it very difficult for prosecutors to prove beyond a reasonable doubt the necessary element of criminal intent.
(Parenthetically, if so, what does that tell us about the adequacy of disclosure rules and the ability and efficiency of our most sophisticated market players to understand this information?)
But let me focus on the information that we know was NOT disclosed, both in the case of Washington Mutual as uncovered by the staff of the Permanent Subcommittee on Investigations and Lehman Brothers as described by the bankruptcy Examiner's Report.
As early as 2005, internal audits by WaMu revealed stunning lapses in underwriting standards. An audit of two large Southern California origination offices had confirmed fraud rates of 58 and 83 percent.
The extensive -- and perhaps systemic -- fraud uncovered by these audits was never disclosed, and yet WaMu officials chose to continue with business as usual.
Just last month, two witnesses before the Financial Crisis Inquiry Commission alleged similar cover-ups. Clayton Holdings, a firm that reviewed loans filed on behalf of investment banks, noticed significant underwriting deficiencies in the loans sold for securitization in 2006 and 2007, yet investment banks continued to package the mortgages and sell the resulting securities to investors, never disclosing Clayton's findings.
Was this material information that WaMu and other banks had a duty to disclose to investors? That is for prosecutors, judges and juries to decide; but it sure looked that way to committee investigators.
Another example of likely fraud is described by the Examiner's Report in the bankruptcy of Lehman Brothers, which concluded that Lehman executives manipulated the balance sheet by failing to disclose Repo 105 transactions. In fact, the whole purpose of these short-term transactions was to suggest capital reserves were higher by $50 billion than they actually were just before reporting periods.
Finally, recent revelations about the foreclosure mess strongly indicate that fraud -- and possibly criminal perjury -- were system-wide at many of the loan servicers selected by the banks.
And just as troubling for the derivatives markets, there may have been fraud or systemic recordkeeping failures (or both) that will cloud title for many securitized mortgages.
Question 2: Has the law enforcement response to the financial crisis so far been adequate to deter financial fraud?
Twice, Chairman Leahy has asked Senator Kaufman to chair oversight hearings on FERA, in December 2009 and again in September 2010.
At those hearings -- which featured officials from the Justice Department, FBI and SEC -- Senator Kaufman expressed his full support and appreciation for the hundreds of law enforcement personnel who are working tirelessly on this effort, but also voiced his frustration about the lack of prosecutions against executive and boardroom-level officials.
Many commentators have asked: Where are the cases? There have been many successful cases brought against mortgage brokers, as well as an impressive list of recent cases against Ponzi schemes and insider trading. But after the Bear Stearns verdict, we have seen no further criminal indictments at major firms for behavior connected with the financial crisis.
As for civil suits brought by the SEC, two federal judges have each put the question squarely on the table: Are the SEC settlements achieving the level of deterrence that the facts demand? Are they holding the responsible individuals adequately to account? Or are they in effect just sending a bill to be paid by the current shareholders?
As for WaMu officials, why hasn't the US Attorney in Seattle brought a case? Or the SEC against former Lehman Brothers executives? I really don't have a clue.
The role of Congress stops after asking whether the agencies are coordinating and engaged in a foundational strategic approach and whether there are any systemic obstacles preventing effective law enforcement.
The Justice Department and SEC have testified publicly that they are continuing a robust investigative effort and that cases are still in the pipeline. These are no doubt complicated cases that take time to develop.
Regardless of the election results, I predict the new Congress will continue to demand accountability and provide law enforcement with all the resources it needs to pursue complex financial fraud. It's good policy and good politics -- for BOTH parties.
Question 3: Does federal law enforcement have in place systems that permit it to monitor and uncover ongoing fraud and manipulation?
Well, clearly not, as the experience of the last two years demonstrates.
First, the FBI cannot do the investigative work alone.
Senator Kaufman has repeatedly urged the bank regulatory agencies to play a stronger role in developing criminal referrals, as was ultimately the case in the Savings & Loan crisis.
The WaMu hearings revealed that the Office of Thrift Supervision was almost a fraud enabler.
This regulatory culture must change, and it is.
Between the first oversight hearing in December, 2009 and the second in September, 2010, the number of criminal referrals provided by the bank regulatory agencies has increased from ZERO to a small but significant number, according to the Justice Department.
Second is an example Senator Kaufman has focused on extensively in the past 15 months: Technology advances in trading markets have caused law enforcement and regulatory agencies to fall far behind in their ability to monitor and detect manipulation by high-speed, algorithmic traders.
In only a few years time, the equity markets have jumped from two exchanges to more than 50 trading venues, becoming so mind-numbingly complex that even professional traders have difficulty telling you with confidence what happens to their orders.
As we've moved from floor-based to electronic systems, the systems that undergird regulatory surveillance have become ridiculously outmoded.
After the May 6 flash crash, it took armies of SEC and CFTC staff more than three months to collect and analyze the trading activity for that single day. What does that say about their ability to monitor that activity in real time on an ongoing basis?
This is not a new problem. After Black Thursday in 1987 and another market event in 1989, Congress passed the Market Reform Act in 1990 to expand the SEC's authority to enhance its ability to recreate unusual trading days and to detect illegal trading activity. In 20 years, the SEC has never used that authority!
The Commission proposed a rule in 1991 and then re-proposed it in 1994, but never adopted it.
Finally, on April 14, 2010, the Commission proposed a rule that would require tagging of high frequency and other large volume traders.
And because of the proliferation of market venues, we have huge gaps in the audit trails collected by the exchanges, and so the Commission after the flash crash also proposed a consolidated audit trail. We'll see if the Commission finally adopts these rules.
In the meanwhile, do we know whether some algorithmic traders -- whose servers are co-located at every exchange, who trade in microseconds and whose volumes currently represent 70 percent of the daily trading in the equity markets -- are engaged in manipulation? How can we know, one way or the other?
The systems still aren't in place to monitor and police their activity.
Neither has the Commission provided any guidelines for what type of electronic trading behavior in the current microsecond environment would equate to manipulation.
We've heard concerns from the SEC about spoofing or layering (when orders are issued and immediately cancelled for the purpose of feigning interest in buying a stock to manipulate its price), momentum ignition strategies, liquidity detection strategies that enable front-running of mutual fund and pension fund orders, and most recently about quote stuffing (when a trader enters a huge numbers of electronic orders in an effort to slow one market center and capitalize on latency arbitrage opportunities at other market centers).
Without guidelines or monitoring, as Senator Kaufman has said repeatedly, it's like the Wild West.
In Australia, in a review of algorithmic trading published February 8, the Australian Securities Exchange called on the Australian Securities and Investments Commission to, "Ensure that... market manipulation provisions... are adequately drafted to capture contemporary forms of trading and provide a more granular definition of market manipulation."
In the UK, noting that some market participants may not be sure that spoofing or layering is illegal, on September 1, 2009, a spokeswoman for the Financial Services Authority said, "This is to clarify that it is."
FINRA, to its credit, recently brought a manipulation case that resulted in fines and individual bans against an electronic trading firm named Trillium, but that was for activity that took place four years ago.
Clearly, that's not enough.
Finally, to my last question: Why should all of us care? I think we can all agree that effective law enforcement is vital to preserving the credibility of our capital markets; that our economy cannot succeed in the long-term unless we restore and maintain financial stability; and that investor confidence is critical to the success of the market.
But this is not a job for law enforcement alone.
Wall Street should recognize that it is in its long-term interests to work cooperatively with government to curb Wall Street excesses.
The actions of a few bad apples -- if they go undetected and unpunished -- can indeed put in peril confidence in the entire system.
If not, it won't be long before a consensus will form among non-financial U.S. companies and millions of American investors: "We're going to strongly support government efforts to stop any and all reckless behavior before it hurts the economy again."
It's mindboggling to me that the financial crisis was not horrific enough to bring about wholesale and effective change now. If extensive fraud is uncovered in the foreclosure mess, with much of the action taking place at the state, not federal level, I predict the public's reaction will not be tame.
As for the equity markets, however, Americans vote today in the polling booths, investors will continue to vote with their feet if they believe the markets are rigged against them.
Senator Kaufman's term, and my time as a Senate staffer, has ended, but this is not a fight for one Senator to wage. These are questions that go to the foundations of the rule of law and America's future economic success.
For the common good, I hope you answer them well.