Read an Excerpt
Better Bankers, Better Banks
Promoting Good Business Through Contractual Commitment
By Claire A. Hill, Richard W. Painter The University of Chicago Press
Copyright © 2015 The University of Chicago
All rights reserved.
ISBN: 978-0-226-29319-6
CHAPTER 1
Irresponsible Banking
In the spring of 2015, over six years after the 2008 financial crisis, and after the flood of regulation enacted in response, bank scandals — some new, some ongoing, and some in the recent past — are still much in the news. In this chapter, we discuss several of these scandals.
The examples we discuss are, of course, in the past, albeit in some cases in the very recent past. How common problematic behavior is now or, for that matter, how common it has been in the past, cannot be known. Certainly, much bank behavior is not problematic. But the behavior we discuss here is sufficiently common that it cannot fairly be considered exceptional or rare.
Many examples we discuss in this chapter involve financial risk taking and financial engineering. These are both part of banks' business models; the difficulties arise because the business models may not distinguish sufficiently well between the appropriate and the inappropriate.
Some examples involve conflicted behavior. It has been suggested that conflicted behavior itself may also be part of some banks' business models, such as when banks design or deal in complex products whose value they can misrepresent to their more credulous customers and clients. Greg Smith, who made headlines in 2012 when he left Goldman Sachs and simultaneously published an op-ed explaining why he had done so, was interviewed by Anderson Cooper on CBS's 60 Minutes. In the interview, he described sales pitches made by "Wall Street" for complex products to "philanthropies, or endowments, or teachers' retirement pensions funds, in Alabama, or Virginia, or Oregon." The aim was, he explained, to get big fees from unsophisticated clients. Cooper then asked: "So, did the people you work with want unsophisticated clients?" to which Smith replied that "getting an unsophisticated client was the golden prize. The quickest way to make money on Wall Street is to take the most sophisticated product and try to sell it to the least sophisticated client." It should be noted, however, that Smith's reasons for leaving Goldman Sachs are disputed and may have included dissatisfaction with his compensation.
Reputation should generally serve as a constraint to conflicted behavior. Apparently, though, there are times when it does not. Such behavior may be particularly tempting when banks (or bankers) are performing badly. Bankers may react in problematic ways, perhaps by attempting to sell bad investments to credulous but technically "sophisticated" customers and clients or by engaging in other undesirable behavior, such as doubling down on, or not fully disclosing, risk.
Just as reputation is not a sufficient constraint against conflicted or otherwise problematic behavior, neither apparently is the effect of the significant amounts banks pay, and presumably expect to pay, in settlements with regulators, especially the U.S. Securities and Exchange Commission (SEC). A New York Times article discussing Citigroup's settlement of a case concerning subprime mortgages, to be discussed later in this chapter, noted that
nearly all of the biggest financial companies, Goldman Sachs, Morgan Stanley, JPMorgan Chase and Bank of America among them, have settled fraud cases by promising the S.E.C. that they would never again violate an antifraud law, only to do it again in another case [and without admitting or denying that they did what they were alleged to have done, but typically paying significant financial penalties] a few years later....
A New York Times analysis of enforcement actions during the last 15 years found at least 51 cases in which 19 Wall Street firms had broken antifraud laws they had agreed never to breach.
Some banks would respond that entry into a subsequent settlement as to the same law does not mean that they violated the prior settlement. This debate is ultimately beside the point being made here, which is that settlements do not seem to be doing enough to prevent future conduct that generates more charges of misconduct — charges that, again, are often settled with significant monetary penalties.
One of the best-known settlements in the years preceding the subprime bubble is the 2003 $1.4 billion global settlement that Bear Stearns, Credit Suisse, Goldman Sachs, JPMorgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, UBS Warburg, and USB Piper Jaffray entered into with the SEC (and the National Association of Securities Dealers, the North American Securities Administrators Association, the New York Stock Exchange (NYSE), the New York attorney general, and state securities regulators), settling allegations that the banks' analysts' reports had been deceptive. The allegations concerned "undue influence of investment banking interests on securities research at brokerage firms." Banks had given "buy" ratings and other favorable coverage to companies whose investment banking business they sought even though they believed the companies were of very low quality. Documents meant for internal consumption within some of the banks used very evocative language to describe just how low. The more polite descriptions include "dog" and "junk"; less polite ones include "piece of crap" and "piece of shit."
Also in the fairly recent past is Enron. Enron collapsed in 2001, having used many bank-crafted techniques to depict its financial condition as far better than it was. One type of transaction Enron used was a "prepay transaction." Prepay transactions can be legitimate, but the SEC alleged that Enron's were not — that they were actually borrowings. JPMorgan and Citi helped Enron structure these transactions and participated in them, effectively lending Enron money. Both paid significant amounts to the SEC to settle allegations that they aided and abetted Enron's securities fraud. In a related proceeding, Citi also settled SEC allegations that it used similar techniques with another company, Dynegy. In these settlements, in accordance with standard practice, the settling companies were allowed to neither admit nor deny the allegations. But they settled for significant amounts of money — JPMorgan agreed to pay $135 million and Citi agreed to pay $120 million. The two banks also agreed to pay over $2 billion each to settle private suits.
The complexity of the transaction structure was intended to fool markets. One banker from JPMorgan explained the prepay structure used by Enron to another banker:
"Why do they want to hedge with gas where it is now?"
"They're not hedging ... they do the back-to-back swap."
"This is a circular deal that goes right back to them."
"It's basically a structured finance —"
"It's a financing?"
"Yeah, its totally a financing"
None of what follows is intended as a wholesale indictment of bankers or banking. Rather, the descriptions below are intended to provide a critical yet nuanced perspective on what banks and bankers did, avoiding reflexive demonization or overgeneralization. There are many different sorts of bankers, with many different roles, aptitudes, temperaments, and levels of knowledge and responsibility. As stated in the introduction, many bankers have done good things for our economy and for society as a whole. But bankers, together, created and inhabited a culture that has permitted, and at times encouraged, behavior that has proven highly problematic. Some of the behavior is clearly illegal. Some of the behavior may be in a gray area. And some may be legal but impose significant costs on many different types of people — taxpayers, homeowners, pension fund beneficiaries, and so on. Some types of misbehavior are probably no longer occurring — and some lessons may have been learned. But the all-too-recent examples in this chapter, many involving significant amounts of money, demonstrate that the problem in banking continues.
Some Examples
The 2008 Crisis: Subprime Securities
Investment banks were the driving force behind the structured finance products that provided a steady stream of funding for lenders originating high risk, poor quality loans and that magnified risk throughout the U.S. financial system. The investment banks that engineered, sold, traded, and profited from mortgage related structured finance products were a major cause of the financial crisis.
That was the conclusion of the 2011 Levin-Coburn Report, the report produced by the Senate subcommittee that investigated investment banks' role in the crisis. The following briefly explains some of the main drivers of the report's conclusion.
Bankers' Responsibility for Bad Mortgages
When borrowers take out mortgage loans, those making the loans typically do not keep them. Rather, they sell them and use the funds to make more mortgage loans. The buyers of these loans — banks and others — pool many mortgages and sell interests (residential mortgage-backed securities, or RMBS) in the pools to investors on the capital markets. The capital markets thus provide financing for mortgages. Not only did banks structure and sell RMBS, they also structured and sold collateralized debt obligations (CDOs) made up of RMBS and other debt obligations. They also directly financed and, in some cases, acquired mortgage originators.
Prime mortgages, which are mortgages to borrowers with good credit, have been successfully sold into these pools for many years. Starting in the early to mid-1990s, banks began structuring and selling interests in pools of subprime mortgages. The subprime mortgages that were pooled, while not of prime quality, were nevertheless purportedly carefully underwritten to be of a specified, albeit lesser, quality. Interests in pools of subprime securities proved quite popular, creating considerable demand for more interests and, thus, more mortgages. Transaction volume rose dramatically in the first decade and virtually exploded in the years immediately preceding the 2008 crisis.
The more demand there was for these mortgages, the more that were made. Moreover, the people originating subprime mortgages were compensated on volume. The demand was there; they just had to provide the supply. That they would try to stretch underwriting standards to and sometimes past the breaking point was to be expected. The subprime mortgages originated and pooled became progressively worse: loans were extended to borrowers with lower credit scores, based on highly inflated house appraisals. In some cases, mortgage originators simply lied. Some borrowers were duped, but some were not: they were willing to take out a mortgage that depicted their financial situation as being far more favorable than they knew it to be. Whether or not lying was involved, considerable ingenuity was devoted to figuring out how to qualify (and indeed, recruit) more borrowers. The term "liar's loans" and a somewhat less evocative one, NINA loans, for "no income no assets," tells the tale. The official terms for some of these loans were "low-documentation" (or even "no doc") or "stated income" (the borrower "stated" his income, and nobody checked). These kinds of mortgages, as well as mortgages requiring very low payments initially but much larger payments later on, where the ability to make the low payments sufficed to qualify the borrower for the mortgages, seem like open invitations to game underwriting standards.
Banks' assembly lines, buying these mortgages and structuring them into RMBS and selling them to investors, continued at breakneck pace. As the market heated up, banks sometimes, and perhaps often, didn't do enough due diligence. However little they knew about the quality of particular mortgages they were securitizing, they were increasingly aware that overall, mortgage quality was declining and that underwriting standards were not being adhered to. Where they knew that particular mortgages were of low quality, there was considerable pressure not to act on that knowledge and refuse to buy the mortgages, lest the sellers of the mortgages decide to take future mortgages elsewhere.
Bankers' Structuring and Sale of Low-Quality Securities
Bankers structured and sold subprime securities they believed were bad, sometimes not fully disclosing and sometimes even affirmatively misrepresenting their views, including to their customers and clients.
Banks selling mortgage-backed securities represented them as being of high quality, with the underlying mortgages comporting with specified underwriting standards. Many lawsuits, both public and private, have been brought, alleging that banks, at best, knew they had not done enough due diligence or, worse, that the banks knew many of the mortgages were questionable. Some of these lawsuits have ended with settlements. The aggregate amounts of the settlements are in the billions, as discussed below, with settlements with one agency, the Federal Housing Finance Agency (FHFA), exceeding $18 billion. Of course, not all cases result in banks' settling or being found liable. Furthermore, even where banks do settle, as noted above and discussed in chapters 4 and 5, they often make no admission of wrongdoing. The settlements may, however, contain agreed statements of facts that can help explain the specifics of the conduct at issue. Moreover, whatever the legal situation may be — whether bank conduct was illegal or not and what the banks may or may not have admitted as part of settlements — considerable evidence has been unearthed, both in the litigation process and in governmental inquiries, that describes conduct of considerable concern. One particularly vivid source is internal e-mails, some of which are quoted or discussed below.
In November of 2013, JPMorgan entered into a $13 billion settlement with, among others, the Justice Department, the FHFA, and various states. The settlement was "to resolve federal and state civil claims arising out of the packaging, marketing, sale and issuance of residential mortgage-backed securities (RMBS) by JPMorgan, Bear Stearns and Washington Mutual [which JPMorgan acquired when they collapsed] prior to Jan. 1, 2009. As part of the settlement, JPMorgan acknowledged it made serious misrepresentations to the public — including the investing public — about numerous RMBS transactions." JPMorgan acknowledged that it "regularly represented to RMBS investors that the mortgage loans in various securities complied with underwriting guidelines. Contrary to those representations, as the statement of facts explains, on a number of different occasions, JP Morgan employees knew that the loans in question did not comply with those guidelines and were not otherwise appropriate for securitization, but they allowed the loans to be securitized — and those securities to be sold — without disclosing this information to investors."
The statement of facts provides useful detail as to the quality of mortgages JPMorgan was securitizing and JPMorgan's knowledge on this point:
JPMorgan contracted with industry leading third party due diligence vendors to re-underwrite the loans it was purchasing from loan originators. The vendors assigned one of three grades to each of the loans they reviewed. An Event 1 grade meant that the loan complied with underwriting guidelines. An Event 2 meant that the loans did not comply with underwriting guidelines, but had sufficient compensating factors to justify the extension of credit. An Event 3 meant that the vendor concluded that the loan did not comply with underwriting guidelines and was without sufficient compensating factors to justify the loan. ... JPMorgan reviewed loans scored Event 3 by the vendors and made the final determination regarding each loan's score. Event 3 loans that could not be cured were at times referred to by due diligence personnel at JPMorgan as "rejects." JPMorgan personnel then made the final purchase decisions.
From January 2006 through September 2007[,] ... JPMorgan's due diligence vendors graded numerous loans in the samples as Event 3's. ... The exceptions identified by the third-party diligence vendors included, among other things, loans with high loan-to-value ratios (some over 100 percent); high debt-to-income ratios; inadequate or missing documentation of income, assets, and rental/mortgage history; stated incomes that the vendors concluded were unreasonable; and missing appraisals or appraisals that varied from the estimates obtained in the diligence process by an amount greater than JPMorgan's fifteen percent established tolerance. The vendors communicated this information to certain JPMorgan employees.
JPMorgan directed that a number of the uncured Event 3 loans be "waived" into the pools facilitating the purchase of loan pools, which then went into JPMorgan inventory for securitization. ... Some JPMorgan due diligence managers also ordered "bulk" waivers by directing vendors to override certain exceptions the JPMorgan due diligence managers deemed acceptable ... without analyzing these loans on a case-by-case basis. JPMorgan due diligence managers sometimes directed these bulk waivers shortly before closing the purchase of a pool. Further, even though the Event 3 rate in the random samples indicated that the un-sampled portion of a pool likely contained additional loans with exceptions, JPMorgan purchased and securitized the loan pools without reviewing and eliminating those loans from the un-sampled portions of the pools.
(Continues...)
Excerpted from Better Bankers, Better Banks by Claire A. Hill, Richard W. Painter. Copyright © 2015 The University of Chicago. Excerpted by permission of The University of Chicago Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
