Smoking Loans Prove Wall Street Committed Fraud

A central question in the financial crisis is whether Wall Street simply made errors of judgment that led to a housing bubble or whether it knowingly broke the law. Did the gun go off accidentally, in other words, or did the shooter aim at the victim's head? That's critical to find out because it informs our approach both to fixing the banking industry and to deterring such conduct in future.

New evidence increasingly points to murder, rather than manslaughter. D. Keith Johnson, former president of Clayton Holdings, a company that assessed the quality of mortgages for banks and credit rating agencies, recently told the Financial Crisis Inquiry Commission that he warned these firms that nearly half the loans were duds. Investment banks used them anyway:

Mr. Johnson said he took this data to officials at Standard & Poor's, Fitch Ratings and to the executive team at Moody's Investors Service (MCO).

"We went to the ratings agencies and said, 'Wouldn't this information be great for you to have as you assign tranche levels of risk?' " Mr. Johnson testified last week. But none of the agencies took him up on his offer, he said, indicating that it was against their business interests to be too critical of Wall Street.

Wall Street firms didn't merely ignore such information; they also used it as intel to negotiate better prices on the loans they bought from originators for packaging into CDOs and other mortgage-backed securities, said another Clayton employee.

Such disclosures go beyond undermining financial executives' claims that they didn't see the crash coming. They illustrate a pattern of intent by big banks to sell financial products they knew were defective. That's not a misjudgment -- it's fraud. As a former white-collar prosecutor recently told me:

If you lie to somebody to get them to give you money, you have stolen money from them.

If it's hard to accept that fraud was central to the crisis, it's largely because the monumental scale of the deception is hard to process. See those trees over there? That's a forest, and it's burning like cordwood. It's also because, during the boom, some of the key operating principles underlying the financial system itself were inverted.

Ordinarily, growing demand for mortgages is what creates demand for mortgage-backed securities. During the housing boom, however, that dynamic got reversed -- surging demand for securities by Wall Street and investors led to an orgy of bad lending. The cart took the horse on a merry old gallop.

That pattern became hardwired into a financial system, encouraging bad behavior. Laws are broken, ethics (if they exist) smashed to bits. Here's how the anonymous financial exec who writes over at The Fourteenth Banker put it:

The profits that were generated by this activity dwarf the potential cost. Executives' incentives are to produce gains today and they do not pay for the risks that are left for tomorrow. The decision to have individual employees sit and sign affidavits that are false was made consciously. Someone decided to save the expense of doing it right. Or someone figured out that the chain of title had already been broken and it is better to whistle past the graveyard and defraud a court, a debtor, an investor, or a shareholder, than it is to do the right thing.

[T]he truth is that decisions to cut corners, commit fraud, abuse clients or mislead investors are generally cognitively rational given the position in which the individual employee is put.

Image from MorgueFile
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• Bad Credit: How S&P, Moody's and Fitch Helped Cause the Housing Bubble
• Street Fight: Time to Send Bankers to Jail