02/12/2013 04:37 pm ET | Updated Apr 14, 2013

Is Wall Street's Business Model Corrupt?

"Given the scope of the allegations to date, we are not talking simply about the occasional corrupt individual. We are talking about something verging on a corrupt business model." -- U.S. Attorney Preet Bharara, NYT, May 27, 2011

As the evidence mounts, the raison d'être for Occupy Wall Street is proving correct. Much of high finance, it seems, is based on a "corrupt business model." Here's a brief tour of its contours. (For more detail please see How to Make a Million Dollars an Hour.)

1. Rating Agencies Turn Tricks for Cash:

The three major rating agencies, by regulation, have special status in our economy. Their job is to help police the financial system by scrutinizing the credit worthiness of new securities created and sold by banks and other financial institutions. The higher the rating, the easier it is to market the securities. (Pension funds, for example, are only permitted to buy highly rated securities. And triple A-rated securities allow banks to hold and count such securities as Tier 1 capital against their loans, an extremely valuable attribute.) During the housing boom, banks found ways to "securitize" junk mortgages to sell to investors all over the world. Even though the underlying sub-prime mortgages were extremely risky, the banks claimed their bundling and slicing techniques made most of the securities extremely safe.

How safe? Well, the banks, using questionable modeling, "convinced" the rating agencies to provide AAA ratings to many of these dubious securities -- the same ratings as those awarded to the safest government bonds. Since the rating agencies are paid by the banks, it's easy to see why these ratings agencies would aim to please their benefactors.

This blatant conflict of interested greatly exacerbated the housing bubble and financial crash. On the way up the AAA ratings allowed for the generation of more and more sub-prime loans. No one cared if those taking out those mortgages could pay them back, or even if the borrowers were still breathing. The goal was to grab the mortgages, securitize them, get AAA ratings, and then pawn them off as fast as possible. After the toxic mortgages metastasized, the rating agencies quickly changed thousands of the AAA ratings to junk status, forcing banks and pension funds to dump the securities into declining markets. This further collapsed prices and intensified the crash. Meanwhile, the rating agencies became among the most profitable companies on Wall Street.

Since the crash, many of us have been screaming for the federal government to break up this prostitution ring. Finally, the Justice Department is asking for $5 billion in restitution from Standard and Poor's. But as far as we can tell, not one penny of the fines comes directly from any of the rating agency executives who so handsomely profited from this scam year after year.

(For a hard-hitting analysis see Marhall Auerback's "Credit Agencies are the Pimps of Wall Street." )

2. Money laundering for Drug Cartels:

The American division of HSBC, which is regulated by the Federal Reserve, is a division of one of largest most profitable banks in the world. Some of those super-profits result directly from massive money laundering in behalf of Mexican drug cartels. This was no mom-and-pop operation. Nor was it the work of just a few rogue bank officials, hoping to skim a few bucks on the side. No, this was the big time, a main event to the tune "at least $881 billion in drug proceeds" laundered through the U.S. financial system according to the Department of Justice. To compound matters, the bank was cited for "willful flouting of U.S. sanctions laws and regulations [that] resulted in the processing of hundreds of millions of dollars in... prohibited transactions" with rogue nations and even terrorist organizations.

The penalty for this blatant corruption is $1.9 billion, which comes to less than six weeks of HSBC's 2011 profits. What about criminal penalties? As the NYT laments in an editorial, "Too Big to Indict":

"It is a dark day for the rule of law. Federal and state authorities have chosen not to indict HSBC, the London-based bank, on charges of vast and prolonged money laundering, for fear that criminal prosecution would topple the bank and, in the process, endanger the financial system. They also have not charged any top HSBC banker in the case, though it boggles the mind that a bank could launder money as HSBC did without anyone in a position of authority making culpable decisions."

3. Creating securities designed to fail and then betting against them:

Imagine this: You sell a car that you claim is safe and sound. But you design it so that it will crash within the first few months of operation. Then you surreptitiously take out insurance on the car in order to collect the proceeds from the accident. You profit when you sell the car. You profit when you collect the insurance. This in a nutshell is how banks and hedge funds colluded in creating disastrous mortgage-related securities called synthetic CDOs.

We are awash with government evidence that the largest banks including JPMorgan Chase and Goldman Sachs worked hand in glove with hedge funds to create mortgage-related securities based on the worst mortgage pools that could be found. In fact, these venerable banks permitted the hedge funds to select the junk mortgage pools in order to make certain the mortgages would fail as soon as possible. The hedge funds then bet against (shorted) the new securities. JPMorgan Chase was fined $296.9 million and Goldman Sachs was fined $550 million for not disclosing these pernicious details to those who were sold the built-to-fail securities. But security law is such that the hedge funds involved were able to keep their booty.

4. Insider trading:

When we say that Wall Street is a casino, we give casinos a bad name. After all, public casinos are regulated, the odds are posted, and the games of chance aren't rigged. Not so with hedge funds and proprietary trading desks within large banks. They like to gamble only when they know the outcome before they bet. Trading on insider information is the method of choice.

Take the jailed billionaire Raj Rajaratnam, for example. His hedge fund made nearly a million dollars in only a few minutes after his source -- a director of Goldman Sachs -- provided a key bit of inside information in the tumultuous fall of 2008. With markets turning against investment banks, Goldman Sachs was to announce after the closing bell that Warren Buffett would invest $5 billion in the investment bank, thereby giving it an enormous seal of approval. The Raj, as he likes to be called, used his illegal tip to net a quick $900,000. To borrow a phrase from Nomi Prins, the former Goldman Sachs managing director, "Even the squirrels in my backyard could make money on that play."

So far, the New York U.S. attorney has nailed approximately 70 hedge fund cheats. Since it is very difficult to prosecute these cases, we can be certain those apprehended represent but a small fraction of those engaged in illegal insider trading.

5. Fixing interest rates:

The London Interbank Offered Rate (LIBOR) is the benchmark interest rate used by lenders all over the world to set short-term adjustable rates on everything from credit cards to car loans. The rate is supposed to reflect how much the largest banks in London would charge to loan money to each other. But bank traders and their hedge fund friends realized that if they could artificially inflate or deflate that rate at will, they could place bets knowing precisely which direction the rates would go and make a certain profit. So they did. Fines are being assessed against bank after bank both here and in London.

And the list goes on and on.

  • The big banks are being fined over $8 billion for illegal robo-signings of home foreclosure documents.
  • They will be fined billions more for selling crap mortgages to Fannie and Freddie.
  • Then there's the utter senselessness of high frequency automated trading which technically is legal.
  • And as Mad Money's Jim Cramer once confessed in a web interview, rumor mongering and media manipulation were key to the hedge fund he once ran.

As Cramer put it, the art of being a successful money manager is to lie: "But what's important when you're in that hedge fund mode is to not do a thing remotely truthful because the truth is so against your view that it's important to create a new truth -- to develop a fiction."

Why so much corruption?

In researching How to Make a Million Dollars an Hour I came across an interesting article by Professor Lynn Stout, a professor at the UCLA School of Law, entitled, "How Hedge Funds Create Criminals." Stout claims that hedge funds, "both individually and as a group can send three powerful social signals that have been repeatedly shown in formal experiments to suppress pro-social behavior." For the ethically-challenged, these signals can create what she calls a "criminogenic" environment that I believe applies to wide variety of financiers, not just hedge fund managers.

Signal 1: "Authority doesn't care about ethics." Clearly, when $881 million in illegal drug money is laundered through a bank, everyone knows that the higher-ups worry little about the ethics of the deal. And how could any top banker or hedge fund manager believe that it is appropriate to create products designed to fail and then bet against them?

Signal 2: "Other Traders aren't acting ethically." From insider trading cases, to mass robo-signings, to LIBOR rate fixing, hedge funds and bankers use the grade school excuse -- "Everybody else is doing it, too!"

Signal 3: "Unethical Behavior isn't Harmful." When what you do is make money from money, it seems as if breaking or avoiding laws and rules create victimless crimes. It's all a big game, where each person is trying to out-hustle the other. It's him or me so what does it matter if we both cheat a bit? But in truth, there are plenty of victims -- like the nine million workers who lost their jobs in a matter of months when the rigged game crashed in 2008. Millions more lost their homes, their savings, and their way of life. Victimless in finance only means that you don't ever see them face to face.

Right now Professor Stout's signals are flashing like strobe lights all over our financial system. The problems are so extensive that nothing short of a massive restructuring stands any chance of success. The steps are obvious: Break up all the big banks. Outlaw the rating agencies. Ban the use of derivatives. And place a financial transaction tax on all sales of stocks, bonds, options, futures, etc.

The choice is clear: Either we put our regulatory feet squarely on the neck of Wall Street like we did during the New Deal through the post-WWII eras, or we become an uglier nation: A billionaire bailout society where too-big-to-fail and too-big-to-jail are a way of life.

Les Leopold is the Executive Director of the Labor Institute and author of How to Make a Million Dollars an Hour: Why Hedge Funds get away with Siphoning off America's Wealth (John Wiley and Sons, 2013)