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Levin Report Postscript: Wall Street and Its Regulators Basically the Same Post-Crisis

Yesterday, Carl Levin introduced his long and relatively effective report on the financial crisis. It focused on four major aspects: mortgage fraud, weak and deferential regulation, the credit rating agencies and investment bank malpractice with mortgage bonds.

Levin said that he referred some issues to the Justice Department for potential prosecution. But we can actually judge how these issues have been dealt with to this point. As Gretchen Morgensen and Louise Story laid out yesterday, the FBI scaled back its mortgage fraud investigations in 2008, even after highlighting the practice in a report as far back as 2005. On the regulation front, we’re eventually getting rid of the OTS, which was highlighted in the report. But their role in the heinous consent decree on foreclosure fraud shows that they remain the model for bank-friendly regulation at the federal level.

What about the other two? Well, Jesse Eisinger wrote this week about Moody’s Investors Service, the credit rating agency, and how their business has hardly changed at all, even after Dodd-Frank.

The government has tried to change the ratings agencies. The Dodd-Frank financial reform law has some bold measures, like making the ratings firms liable for their judgments. Unfortunately, the rules are in danger of not being enforced because of budget constraints and resistance from the agencies.

But the biggest problems at Moody’s may have been cultural. The dominant ethos during the boom, instilled by Brian M. Clarkson, the former president and chief operating officer, was that customer service was Job 1. And the customers were the bankers.

The ability for bankers to run the show has long been an obvious flaw in the ratings system for structured products. Investment banks create the securities and benefit when they receive generous ratings. Banks pay the agencies that supply the ratings. Yet the agencies are somehow supposed to hold the line with the people who are responsible for their paychecks.

To Moody’s credit, Mr. Clarkson is now gone. To Moody’s discredit, however, his philosophy is largely still in place, at least according to Mr. Harrington.

The issuer-pays model hasn’t really changed, so until that’s dispensed with, this will always be the culture at the rating agencies, unless somebody goes to jail for malfeasance. And that hasn’t happened.

As for the mortgage bonds, the SEC is apparently readying a settlement with several Wall Street firms on fraud charges with mortgage bonds. [cont’d.]

The expected settlements, some of which could be reached as soon as next week, collectively mark the biggest attempt by enforcement agencies to hold Wall Street accountable for its role in the subprime mortgage bust.

The cases highlight the aggressive tactics banks used to sell these securities to investors who suffered big losses. They also show how the banks’ desire to keep the $1 trillion mortgage securities business going helped fuel the housing bubble.

The Securities and Exchange Commission is aiming to reach a series of settlements with individual firms over the sales of the investments, rather than a big industrywide deal, according to people familiar with the matter.

The settlements are expected to vary significantly among banks—but few, if any, are expected to surpass the $550 million penalty that Goldman Sachs Group Inc. paid last year to settle allegations that it misled investors in a mortgage-bond investment called Abacus 2007-AC1. That penalty was the largest ever paid by a Wall Street firm to settle SEC charges. Goldman didn’t admit or deny the allegations.

These would be civil settlements – the SEC cannot bring criminal charges, only refer them to DoJ. And the $550 million penalty against Goldman Sachs was widely seen by the industry as an easy punishment. Goldman made more than that off the fraudulent Abacus deal. All of the top banks are involved: JPMorgan Chase, Citigroup, Morgan Stanley, Merrill Lynch, UBS. These are basically CDO cases, where hedge funds betting against the mortgage market helped pick the loans in the deal, and the investment bank sold off the bonds without telling the investors about the hedge fund going short on it. There are additional charges of illegal fees.

So that’s what we’ve got out of all this. No change in culture at the regulatory agencies or the credit raters; no criminal prosecutions; and civil actions and fines that do little if anything to deter the fraud.

I get the feeling that we’re sitting on a ticking time bomb, and we’ll replay this all over again soon.

CommunityThe Bullpen

Levin Report Postscript: Wall Street and Its Regulators Basically the Same Post-Crisis

Yesterday, Carl Levin introduced his long and relatively effective report on the financial crisis. It focused on four major aspects: mortgage fraud, weak and deferential regulation, the credit rating agencies and investment bank malpractice with mortgage bonds.

Levin said that he referred some issues to the Justice Department for potential prosecution. But we can actually judge how these issues have been dealt with to this point. As Gretchen Morgensen and Louise Story laid out yesterday, the FBI scaled back its mortgage fraud investigations in 2008, even after highlighting the practice in a report as far back as 2005. On the regulation front, we’re eventually getting rid of the OTS, which was highlighted in the report. But their role in the heinous consent decree on foreclosure fraud shows that they remain the model for bank-friendly regulation at the federal level.

What about the other two? Well, Jesse Eisinger wrote this week about Moody’s Investors Service, the credit rating agency, and how their business has hardly changed at all, even after Dodd-Frank.

The government has tried to change the ratings agencies. The Dodd-Frank financial reform law has some bold measures, like making the ratings firms liable for their judgments. Unfortunately, the rules are in danger of not being enforced because of budget constraints and resistance from the agencies.

But the biggest problems at Moody’s may have been cultural. The dominant ethos during the boom, instilled by Brian M. Clarkson, the former president and chief operating officer, was that customer service was Job 1. And the customers were the bankers.

The ability for bankers to run the show has long been an obvious flaw in the ratings system for structured products. Investment banks create the securities and benefit when they receive generous ratings. Banks pay the agencies that supply the ratings. Yet the agencies are somehow supposed to hold the line with the people who are responsible for their paychecks.

To Moody’s credit, Mr. Clarkson is now gone. To Moody’s discredit, however, his philosophy is largely still in place, at least according to Mr. Harrington.

The issuer-pays model hasn’t really changed, so until that’s dispensed with, this will always be the culture at the rating agencies, unless somebody goes to jail for malfeasance. And that hasn’t happened.

As for the mortgage bonds, the SEC is apparently readying a settlement with several Wall Street firms on fraud charges with mortgage bonds.

The expected settlements, some of which could be reached as soon as next week, collectively mark the biggest attempt by enforcement agencies to hold Wall Street accountable for its role in the subprime mortgage bust.

The cases highlight the aggressive tactics banks used to sell these securities to investors who suffered big losses. They also show how the banks’ desire to keep the $1 trillion mortgage securities business going helped fuel the housing bubble.

The Securities and Exchange Commission is aiming to reach a series of settlements with individual firms over the sales of the investments, rather than a big industrywide deal, according to people familiar with the matter.

The settlements are expected to vary significantly among banks—but few, if any, are expected to surpass the $550 million penalty that Goldman Sachs Group Inc. paid last year to settle allegations that it misled investors in a mortgage-bond investment called Abacus 2007-AC1. That penalty was the largest ever paid by a Wall Street firm to settle SEC charges. Goldman didn’t admit or deny the allegations.

These would be civil settlements – the SEC cannot bring criminal charges, only refer them to DoJ. And the $550 million penalty against Goldman Sachs was widely seen by the industry as an easy punishment. Goldman made more than that off the fraudulent Abacus deal. All of the top banks are involved: JPMorgan Chase, Citigroup, Morgan Stanley, Merrill Lynch, UBS. These are basically CDO cases, where hedge funds betting against the mortgage market helped pick the loans in the deal, and the investment bank sold off the bonds without telling the investors about the hedge fund going short on it. There are additional charges of illegal fees.

So that’s what we’ve got out of all this. No change in culture at the regulatory agencies or the credit raters; no criminal prosecutions; and civil actions and fines that do little if anything to deter the fraud.

I get the feeling that we’re sitting on a ticking time bomb, and we’ll replay this all over again soon.

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David Dayen

David Dayen