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When Does the Justice Department Get Involved in Financial “Reform”?

The “next big thing” on Capitol Hill is financial reform, where lawmakers will get together and write some rules designed to prevent the next crisis. And there will be fights over whether those rules are strong enough, and whether they have been made foolproof, or whether the banks got enough wiggle room inserted to evade oversight.

But a more pertinent question, given the series of revelations we’ve seen just over the past week has nothing to do whether or not the rules can be strengthened. It’s simply incredible that no major Wall Street figure has been convicted of criminal violations like fraud since the beginning of the crisis. The above video concerns Magnetar, thehedge fund which created risky mortgage-backed investments and then bet against them with credit default swaps, getting rich off the financial meltdown. If that’s not illegal (that’s a good slogan: “Magnetar – It Only Sounds Illegal!”), what would you call this?

It was like a hidden passage on Wall Street, a secret channel that enabled billions of dollars to flow through Lehman Brothers.

In the years before its collapse, Lehman used a small company — its “alter ego,” in the words of a former Lehman trader — to shift investments off its books.

The firm, called Hudson Castle, played a crucial, behind-the-scenes role at Lehman, according to an internal Lehman document and interviews with former employees. The relationship raises new questions about the extent to which Lehman obscured its financial condition before it plunged into bankruptcy.

While Hudson Castle appeared to be an independent business, it was deeply entwined with Lehman. For years, its board was controlled by Lehman, which owned a quarter of the firm. It was also stocked with former Lehman employees.

None of this was disclosed by Lehman, however.

I don’t know how you keep hearing these stories of fraud – accounting fraud, investor fraud, what have you – without the Justice Department getting involved. We want to make banking boring again, and the simplest way to do that is by making absolutely clear that anyone who takes these kinds of risks and plays these kinds of games will go to jail for a long time. If we had a culture of accountability in Washington that would already be happening.

But instead, financial reform will rely on regulators. The very ones that failed the nation during the last crisis. Regulators could not agree on Washington Mutual’s troubles until a week before it crashed. The bank’s primary regulator, the Office of Thrift Supervision, is expected to be dissolved under regulatory reform, but the normally respected FDIC was found at fault in the WaMu case as well:

But the report also leveled unexpectedly sharp criticism at the F.D.I.C., which by July 2008 concluded that the bank needed $5 billion in capital to withstand future potential losses. The report said the F.D.I.C., which had questioned the Office of Thrift Supervision’s assessments of the bank’s soundness, could have stepped in earlier and acted as the primary regulator, but decided “it was easier to use moral suasion to attempt to convince the O.T.S. to change its rating.”

Hearing on WaMu begin today, but you can summarize the case study thusly: WaMu executives knowingly created extremely risky products, “manufactured” lending documents, securitized loans despite fraudulent loan statements, and the regulators looked away. I’m puzzled why the appropriate response means new regulations and not criminal prosecutions. We may see a dawning of that idea this week – subcommittee chair Carl Levin has left open the possibility of referring the WaMu matter to the Justice Department.

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David Dayen

David Dayen