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Will New York's Attorney General Finally Nail the Banks?

Proving that banks shaded the truth about mortgage-backed securities should not be very hard. Many on Wall Street suspected or knew these assets were toxic even as they continued to promote them to investors.
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Eric Schneiderman has big shoes to fill as New York State Attorney General. Eliot Spitzer famously used this post to crack down on Wall Street after the excesses of the dot com era, going after the likes of Henry Blodget and AIG's Hank Greenberg. Schneiderman's immediate predecessor, Andrew Cuomo, busted up a "pay for play" operation at the New York state pension fund, sending former state comptroller Alan Hevesi and others to prison.

So how will Schneiderman make his mark? Well, judging by news reports on Tuesday, the New York AG is hoping to be the first law enforcement official to hold the big banks accountable for the subprime mortgage crisis -- starting with Bank of America, Goldman Sachs, and Morgan Stanley.

This move confirms what many New Yorkers already know about Eric Schneiderman: He is a committed progressive and also a fighter. That's not so common in a state where top Democrats often act like moderate Republicans. (Exhibit A: Governor Cuomo's grossly unfair budget that lowers taxes on the rich while enacting draconian cuts to education and health care.)

Schneiderman is tapping into the public's deep frustration that nobody -- and I mean nobody -- has yet been held criminally responsible for the systematic deception, conflicts of interest, and excessive risk-taking that surrounded the securitization of subprime mortgage debt by Wall Street banks.

Schneiderman's intervention is clearly needed. For various reasons, detailed recently in an extraordinary New York Times investigation, federal authorities have totally dropped the ball in ensuring justice following the financial crisis. In contrast, the Savings and Loans scandal of the 1980s resulted in no fewer than 800 bank officials going to jail. Major figures in the last wave of corporate scandals also went to prison, including Bernie Ebbers of Worldcom, Jeffrey Skilling of Enron, and Dennis Kozlowski of Tyco.

The Times article notes that while criminal intent is difficult to prove:

legal experts point to numerous questionable activities where criminal probes might have borne fruit and possibly still could. Investigators, they argue, could look more deeply at the failure of executives to fully disclose the scope of the risks on their books during the mortgage mania, or the amounts of questionable loans they bundled into securities sold to investors that soured.

This is where Schneiderman comes in. Thanks to the Martin Act of 1921, which was revived by Eliot Spitzer, the New York AG has wide powers to go after the banks. The Act includes a broad definition of fraud and, crucially, it doesn't require prosecutors to prove criminal intent to defraud -- which is required under federal securities laws. As a primer on the Martin Act explained in 2004:

the only elements needed to establish a Martin Act violation are a misrepresentation or omission of material fact when engaged in to induce or promote the issuance, distribution, exchange, sale, negotiation or purchase of securities.

Proving that banks shaded the truth about mortgage-backed securities should not be very hard. Many on Wall Street suspected or knew these assets were toxic even as they continued to promote them to investors. Civil litigation against the banks has already turned up damning evidence about the banks' internal knowledge of shady underwriting on loans that were bundled into securities. All Schneiderman needs to do under the Martin Act, it would seem, is find evidence of these private doubts and then contrast them to public cheerleading and he has his case.

Veteran observers of Wall Street chicanery will recall the simplicity of Eliot Spitzer's case against the investment analysts Jack Grubman and Henry Blodget. Spitzer subpoenaed the email traffic of these guys and found them ridiculing the very stocks they were promoting at the behest of their investment banker masters. I bet the same kinds of emails can be found about mortgage-backed securities.

Now the bad news: Even if Schneiderman finds some smoking guns, it's unlikely that anyone will face a judge and jury, much less prison, as a result of the AG's investigation. Why? Because actually trying these cases would be hugely expensive and time consuming, requiring resources that may be beyond the AG's office. Recall that Enron's Jeff Skilling and Ken Lay spent as much as $70 million defending themselves against charges that they misrepresented Enron's financial position and the case dragged on for years before a conviction.

Even Eliot Spitzer didn't bring any Wall Street big shots to trial on criminal charges. Instead, he got them to agree to civil settlements in which they paid large penalties to the government -- although not as large as the fortunes they made. Blodget and Grubman both walked away from their confrontations with Spitzer as wealthy men. And, in their settlements with the AG, they didn't admit to any wrongdoing.

Some justice may well emerge from Schneiderman's worthy effort -- like big civil penalties -- but it is not likely to be satisfying.