Why Judge Rakoff Was Right to Block the Citigroup Settlement

On a day when Barney Frank, the feisty Democrat who co-authored the 2009 financial-reform bill, announced that he will be stepping down from Congress, it was fitting that the fallout from the financial crisis of 2007-2008 was back in the headlines. In refusing to accept the $285 million proposed settlement between the Securities and Exchange Commission and Citigroup over the sale of toxic mortgage securities, Judge Jed S. Rakoff, of the U.S. District Court, did the American public a great service.

At issue is not just the $700 million in losses that investors suffered as a result of purchasing a particularly unwholesome credit default obligation (C.D.O.) that Citi put together, marketed, and bet against just as the housing market was collapsing. What is at stake is the government’s overall failure to bring to book Wall Street for its conduct during the credit bubble. More than three years after the collapse of Bear Stearns and Lehman Brothers, none of the other Wall Street firms involved in creating and selling subprime securities has received anything more than a slap on the wrists. And so far the Justice Department hasn’t brought criminal charges against anybody.

The S.E.C.’s case against Citi was a civil one, and Judge Rakoff, in his ruling (pdf), summarized it admirably:

After Citigroup realized in 2007 that the market for mortgage-backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as “Class v Funding IIIU”) that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup’s misrepresenting that the Fund’s assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negative projected assets and had then taken a short position in those very assets it had helped select. Having structured the fund as a vehicle for unloading these assets, dubious assets on unwitting investors, Citigroup realized net profits of around $160 million, whereas the investors, the S.E.C. later revealed, lost more than $700 million.

In a stinging fifteen pages, Judge Rakoff called the settlement between the S.E.C. and Citigroup, which was agreed to in October, a sop to the troubled megabank, noting that it was charged only with negligence rather than fraudulent intent; it didn’t admit any wrongdoing; and it received a fine that was “pocket change” to such a huge institution. “If the allegations of the complaint are true, this is a very good deal for Citigroup; and, even if they are untrue, it is a mild and modest cost of doing business,” Rakoff wrote.

If this were a one-off it would be worrying enough. But this is the third such settlement that the S.E.C. has reached with Wall Street banks. In July of last year, Goldman Sachs paid $550 million to settle a case relating to the notorious Abacus deal, in which the investment bank secretly allowed the billionaire hedge-fund manager John Paulson to select some of the mortgage securities underpinning a C.D.O. even though he was planning to short it once the deal closed. In July of this year, JPMorgan Chase settled a C.D.O. case involving a different hedge fund, Magnetar, for $153.6 million. As in the Citi case, the government allowed both Goldman and Morgan to settle without admitting any wrongdoing.

In seeking to settle cases of this nature, banks have three primary aims: to avoid admitting any wrongdoing (such an admission could be used against them in subsequent lawsuits); to avoid going court, where emails and other embarrassing internal documents would be made public; and to persuade the government not to investigate similar deals the firm was responsible for, thus capping its overall liability. In the Citi case, and in the two previous ones, the banks achieved all of their objectives. While the S.E.C. hasn’t said publicly that it has agreed not to pursue further investigations of Citi, Goldman, and Morgan, the banks’ lawyers have said as much, and the government hasn’t contested their statements.

If Judge Rakoff smelt a rat, he wasn’t the only one. Ordinary criminals rarely get the chance to settle charges against them without admitting they have done wrong and violated the law. Why does the S.E.C. treat Wall Street firms any differently? Judge Rakoff pointed out that in a civil complaint filed against an individual who worked at Citi, Brian Stoker, the S.E.C. did accuse Citi of knowingly misleading investors, which, in Rakoff’s words, “would appear to be tantamount to an allegation of knowing and fraudulent intent.” But in settling with the bank as a whole, the S.E.C. invoked the much lesser charge of negligence.

The head of enforcement at the S.E.C., Robert Khuzami, released a lengthy statement saying Judge Rakoff’s judgement “ignores decades of established practice throughout federal agencies and decisions of the federal courts.” That may well be true, but that only raises larger questions about the cozy relationship between Wall Street and its primary regulator. Khuzami is, by all accounts, a tough and able lawyer, who earlier in his career worked for more than a decade in the office of the U.S. Attorney for the Southern District of New York. But he subsequently spent seven years in a highly remunerated position at Deutsche Bank, one of the firms that the S.E.C. is now investigating. After that experience, Khuzami would hardly be human if he hadn’t come to view the world at least partly through the lens of Wall Street.

I say all this as someone who argued in my 2009 book, “How Markets Fail: The Logic of Economic Calamities,” that misaligned incentives and over-optimism rather than outright crookery were at the heart of the subprime meltdown. Back then, I wrote,

My perhaps controversial suggestion is that Chuck Prince, Stan O’Neal, John Thain, and the rest of the Wall Street executives whose financial blundering and multi-million dollar pay packages have featured on the front pages during the past two years are neither sociopaths, nor idiots, nor felons…. Some of these men, perhaps many of them, harbored doubts about what was happening, but the competitive environment they operated in provided them with no incentive to pull back.

I stick by those words. But in 2009 I wasn’t aware that, as the subprime market was crumbling, Citi, Goldman, and other firms were cooking up deals with hedge funds that made a killing from shorting the securities that other, less informed, clients of the firms ended up holding. Was Prince, Citi’s C.E.O. at the time, aware of what his employees were doing? If not, why not? Did Lloyd Blankfein know that Goldman was doing roughly the same thing? How much did Jamie Dimon, who has largely escaped criticism, know about the Magnetar deal and similar ventures that JPMorgan was involved in?
Since none of the S.E.C.’s cases has gone to court, and the government has published only a minimal amount of factual evidence to support its case, it is impossible to tell how widespread the misconduct was, or how high up it went. Above all else, it was the S.E.C.’s failure to pursue its investigation to the point where it could shed light on these sorts of matters that prompted Judge Rakoff to take the action he did. “In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth,” the judge wrote.

To which I can only add: Amen.

Origin
Source: New Yorker