Normative Narratives

Economic Outlook: Accountability and Oversight in the Financial Sector

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In February I wrote a blog titled “Helping the Poor and Changing Our Standards, The DoJ vs. S & P“, and promised to keep my readers up to date on this important case. For those who do not wish to reread that whole post, here are the most pertinent details:

“The Justice Department plans to file civil fraud charges against the nation’s largest credit-ratings agency, Standard & Poor’s, accusing the firm of inflating the ratings of mortgage investments and setting them up for a crash when the financial crisis struck.”

“The Justice Department has decided to sue S & P for $5 billion. S & P contends it did no wrongdoing leading up to the housing crisis. The company will point to the facts that the Fed didn’t even know the severity of the housing bubble just days before it popped, and that its ratings were similar to those of other agencies.”

“The case is said to focus on about 30 collateralized debt obligations, or C.D.O.’s, an exotic type of security made up of bundles of mortgage bonds, which in turn were composed of individual home loans. According to S.& P., the mortgage securities were created in 2007, at the height of the housing boom. S.& P. was paid fees of about $13 million for rating them.”

Here’s the role the DoJ will argue S&P played in perpetuating the housing bubble:

“The three major ratings agencies are typically paid by the issuers of the securities they rate — in this case, the banks that had packaged the mortgage-backed securities and wanted to market them. The investors who would buy the securities were not involved in the process but depended on the rating agencies’ assessments.”

“In its complaint against S&P, the Justice Department accused S&P of defrauding Western Federal Corporate Credit Union, and other institutions that purchased certain securities based on the high ratings by S&P.

Some credit unions are required by law to rely on credit ratings issued by firms that included S&P in making its investment decisions, the complaint said.”

It is my pleasure to inform my readers that a judge has given this case the “green light“, a step towards holding S & P accountable for its role in the financial crisis:

“The U.S. government may proceed with its $5 billion lawsuit accusing Standard & Poor’s of misleading investors by inflating its credit ratings, after a federal judge rejected the rating agency’s effort to dismiss the civil fraud case

In a written decision late on Tuesday, the judge said the government could pursue claims that S&P manipulated ratings to boost profit, and in doing so, concealed credit risks and conflicts of interest.

This led to large losses for investors and contributed to the 2008 financial crisis, the government contended.

“The government’s complaint alleges, in detail, the ways in which none of S&P’s credit ratings represented the thing that they were supposed to represent, which was an objective assessment of creditworthiness, because business considerations infected the entire rating process,” wrote U.S. District Judge David Carter, in Santa Ana, California.”

“The lawsuit accused the largest U.S. credit rating agency of inflating ratings to win more fees from the issuers and bankers that pay for them.

It also said S&P failed to downgrade ratings for collateralized debt obligations despite knowing they were backed by deteriorating residential mortgage-backed securities.

According to the complaint, S&P rated more than $2.8 trillion of RMBS and nearly $1.2 trillion of CDOs from September 2004 to October 2007.”

“S&P argued that, since the issuer banks had access to the same information and models that S&P analysts did, they could not have been fooled by faulty credit ratings,” Carter wrote.

“This begs the question: If no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting that, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness?”

This is indeed welcome news, as I am sure once the case is underway more information will be brought to light. While I do not take a normative stance on credit agencies in general, the effects of large agencies (such as S & P) ratings on financial valuation cannot be overstated.

To the extent that the lawsuit will explore what role S & P played in perpetuating the financial crisis, and then hold S & P accountable for that role, the judges decision is one that benefits society as a whole by overcoming the power-asymmetry / collective action problem(s) individuals face in holding large institutions to account. Since that is essentially what Normative Narratives is all about, I am happy that the judge will let this case go forward. Of course the wheels of justice move very slowly, so it could still be months / years until a final ruling is made/ appeals finish and any money is paid back, but this decision is a step in the right direction. Any money the U.S. government gets from this case should go towards helping people with refinance underwater mortgages; evidence suggests that low-income families were specifically targeted by lenders in the years leading up to the housing market collapse.

Part of learning from past mistakes is holding the actors who perpetuated / profited from them accountable. Another part of learning from past mistakes is putting safeguards in place to prevent them from occurring again. The former has been addressed on an ad-hoc basis (many would argue not enough has been been done, but lets not allow the unattainable pursuit of perfection get in the way of achievable progress). The later was partially addressed this week with the confirmation of Richard Cordray as the head of the Consumer Financial Protection Bureau:

“The Consumer Financial Protection Bureau was conceived by a Harvard professor, embraced by the Obama administration and pushed into law by Congressional Democrats determined to expand the federal government’s authority to protect borrowers from abusive lending practices”

” [Senator Elizabeth] Warren proposed the creation of a federal agency to protect consumers of financial products in a 2007 article, memorably arguing that the government put more effort into ensuring the safety of toaster ovens than the safety of mortgage loans. The idea resonated with Mr. Obama and his senior advisers, and it became a centerpiece of the administration’s proposal to overhaul financial regulation.”

“‘It is a truly historic day,’ Warren told reporters before the vote. ‘There’s no doubt that the consumer agency will survive beyond the crib. There is now no doubt that the American people will have a strong watchdog in Washington.’”

“…the agency has begun to assert authority over non-bank financial companies, including mortgage and payday lenders, but its actions have been shadowed by uncertainty about the legality of Mr. Cordray’s appointment.”

“‘Today’s action brings added certainty to the industries we oversee and reinforces our responsibility to stand on the side of consumers and see that they are treated fairly in the financial marketplace,’ Mr. Cordray said in a statement.”

It remains to be seen how effective an institution the Consumer Financial Protection Bureau will be. But given the optimism of high ranking officials and the efforts that went into preventing Mr. Cordray’s appointment, it is safe to assume this is big news in the realm of financial reform.

I leave you with words from a previous blog of mine on the subject of accountability, which I believe continues to ring truer and truer with each passing day.

Despite the political and economic cynics out there, who in their great “wisdom” will tell you nothing is happening to hold powerful interests accountable for their role in the financial crisis, we have learned lessons (albeit incredibly hard learned lessons) and are taking steps to ensure we do not repeat our past mistakes.

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10 thoughts on “Economic Outlook: Accountability and Oversight in the Financial Sector

  1. Bzupnick,
    What is your ideal deterrence for financial criminals? Would it be monetary fines, most paid by the stockholders of the corporation that the criminal works for, or real jail time, in a “real” jail with Big Bubba? My understanding is that in China financial criminals, after being convicted, are sometimes given the death sentence. I am not for the death sentence, but I am simply pointing out that if their is no real risk for financial criminals they will not stop committing the crimes. Let’s face it, a man who steals $50 worth of food to feed his family receives more punishment than someone who steals $50,000,000.
    Thank you,
    Jerry

    Like

    • Hey Jerry,

      Evidence suggests that financial crime has been prosecuted more frequently post-Great Recession.

      http://www.fbi.gov/stats-services/publications/financial-crimes-report-2010-2011

      As I stated in my blog post(s), it is difficult to determine exactly which individuals should be held to account for financial crimes (the CEO, the financial engineer, the salesman), making individual convictions very difficult, particularly for top execs who have virtually endless resources for legal proceedings. While these cases should be pursued by the DoJ, prior experience tells us that proving “beyond a reasonable doubt” (criminal case) that high profile execs were responsible for financial crimes (and therefore holding them accountable) will in many cases not be possible (even if as a society we know their negligence or direct orders allowed illicit practices to persist).

      Fines (based on sound economic analysis of the true burden on society) should be large enough to deter future violations, not token amounts that do not affect an actors behavior. Is $5 bn not enough to ask for from S & P, maybe not, I would hope the government already has a scientific means of figuring out how much to fine guilty parties.

      There is also the issue of disbursement, as any fines collected in a criminal case go to the government. The ability of the government to put these moneys back into programs benefiting people who were negatively effected by the illicit practice in question will go a long way in determining how effectively the government provides redress for those affected by financial crimes.

      It is often easier to bring a case against an institution itself, because it is easier to prove that an institution is responsible for some outcome than any specific person within that institution. While it is true that investors may suffer from these sort of fines, if a company attempts to shift the entire burden on the stockholders their will be backlash and investor flight. The liquidity of stocks provides a powerful incentive for companies not to shift losses onto stockholders.

      This is why I look forward to new regulations and watchdog groups that can help prevent future financial crime and protect vulnerable people who are the targets of financial crime. Hopefully the Consumer Financial Protection Bureau does what its title mandates.

      I may have gotten a bit off topic. To answer your question, a combination of fines that truly deter future action (and not taking future profits, but real fines here and now that hurt) and jail time would be the best deterrent imo. The two penalties should complement each other.

      I would be all for a freezing of guilty parties assets and a full IRS investigation into exactly how that party benefited from financial crimes, in order to figure out a fitting penalty.

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  2. How do you feel when you hear Attorney General Eric Holder say that pursuing prosecutions would “hurt the economy”? There is no difference between the man who steals $50 worth of food and the man who steals $50,000,000 but that the $50 criminal has no prosecutor letting him off the hook. The only difference regarding “hurting the economy” between the small and large criminal is scale. The economy of the $50 criminal’s family and perhaps friends will be hurt while he gets punished, as well as his reputation. This is not true equal justice. The $50 guy simply cannot buy his way out of it as those on Wall Street do time and time and time again. I am not one who proposes “hanging them in the streets” but given the worldwide negative effects of the massive criminality, (economic downturns, unemployment, austerity, public revolt) such criminality simply has to be stopped for good.
    Thank you,
    Jerry

    Like

    • I would say he is stating that too big to fail institutions should be abolished (and I agree), which would be the responsibility of Congress not the AG.

      I agree with you that financial criminals should be held to account; so should war criminals, human rights violators, and any actor that imposes negative externalities on society as a whole.

      But stamping our feet and saying this must stop wont work. We need educated and informed global citizens who will hold governments to account at the ballot box. We need solid alternatives, not just wishful thinking.

      And we must realize that these goals will not happen quickly or linearly. Vested interest will not relinquish power-asymmetries willingly. As a global community we need resolve, not cynicism or complacency. We must realize that progress is meaningful and not let the impossibility of perfection break our resolve.

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  3. Thank you for your efforts to educate and inform the people around the globe. You are absolutely correct when you say that resolve is needed, and plenty of it.
    Best regards,
    Jerry

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    • It’s my pleasure Jerry. And I thank you for participating in these important debates with me, as looking at others perspectives ( along with a lot of patience ) is I believe the only way to come up will robust solutions to the worlds problems.

      I hope other viewers follow your lead and begin to become move vocal as well!

      Like

  4. I agree. There are sometimes underestimates of the value of forums like this to deliver positive consequences, I was wondering what your thoughts were about Bill Black. He seems to be very articulate on matters such as these. I’ve watched a number of interviews of him, including Bill Moyers Journal, and his experience during the 1980’s savings and loan scandal where 100’s of financial executives were prosecuted seems most germane on this issue.
    Thanks,
    Jerry

    Like

  5. Bzupnick,
    Bill Black is an assistant professor of law and economics at Southwest Missouri State. If you go to YouTube type in “Bill Black Bill Moyers” and there you are. Just for clarification, are you familiar with Bill Black? Also on YouTube type in “Brooksley Born Frontline The Warning” about derivatives Ms. Born tried to regulate but was unsuccessful / blocked. Then type in “Inside Job Charles Ferguson”. There are other revelatory productions but these seem to “cut to the chase” so to speak.
    Thanks,
    Jerry

    Like

    • I’m not familiar w Bill Black.

      Another potential penalty, which the SEC is trying to impose on Steven Cohen, is banning from the financial services industry.

      I did not know such penalties existed. They could certainly act as a strong deterrent to financial crimes.

      Like

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