Inside Job (23 page)

But whatever their shortcomings, at least Paulson and Bernanke were completely focused on avoiding the collapse of the system once the crisis began. The same cannot be said for everyone else.
Consider, for example, John Thain, someone else I have known slightly for many years. Thain had been Goldman Sachs’s president and co-COO until 2004, then CEO of the New York Stock Exchange.
Thain became CEO of Merrill Lynch in November 2007, replacing Stan O’Neal after O’Neal took his $161 million in severance payments.

While making my film, I spoke frequently and in detail with Thain, who agreed to talk to me on the condition that our conversations remained off the record. Without going into details, I can say
that John
was not big on accepting personal responsibility—not for Goldman Sachs’s behaviour in the Internet bubble, not for Goldman’s massive lobbying for
deregulation, and not for the failure of FINRA (which until 2007 was under contract with the New York Stock Exchange, of which Thain was then CEO) to do anything whatsoever about investment
banks’ conduct during the bubble. But it was John’s behaviour at Merrill that was perhaps most revealing, not just about him but about banking culture generally. Before starting at
Merrill, Thain obtained a $15 million cash sign-on bonus and a first-year compensation package that would have given him over $80 million if Merrill’s share price had recovered. But, of
course, Merrill’s stock didn’t recover, since Merrill proceeded to lose almost $80 billion during the crisis.

John was one of the CEOs summoned by Paulson to meet at the New York Fed over the weekend of 12–14 September 2008—the meetings at which Paulson tried and failed to find a rescuer for
Lehman. There were two potential buyers: Barclays and Bank of America. But with Lehman’s obvious collapse, and with Paulson telling him directly to look for a buyer, John saw the handwriting
on the wall. By accounts, he excused himself from the meeting to make a phone call—without telling Paulson what he was doing. John’s phone call was to the CEO of Bank of America, and
pretty soon BofA was no longer interested in Lehman. This may have sealed Lehman’s fate, since Barclays was prevented from buying without the approval of British regulators—who refused
it.

Less than forty-eight hours later, John had signed a definitive contract for the sale of Merrill Lynch to Bank of America. That contract, even though negotiated and drafted faster than any
comparable acquisition in history, was very carefully constructed so that Merrill, and John Thain, retained control over the payment of bonuses until the acquisition closed in January 2009. Then,
one month after Merrill’s acquisition and Lehman’s bankruptcy, on 13 October 2008, Henry Paulson summoned the CEOs of America’s nine largest banks, once again including John
Thain, to a secret meeting in Washington, DC. Paulson ordered them to accept $250 billion in emergency capital funding, both to strengthen them in reality and to reassure the public. Thain had only
one concern, and he asked Paulson about it: would this affect their freedom to award bonuses? The answer was no.

Then, in December, Thain actually awarded those bonuses—two months early, in order to guarantee that they would be paid before Bank of America took control. Despite the fact that Merrill
had already lost about $50 billion, the bonuses totalled nearly $4 billion in cash, heavily concentrated at the top. Over seven hundred people received bonuses exceeding $1 million each, and
several were in the tens of millions. John had asked for a $10 million bonus for himself, which was refused. The bonuses could not have been paid without the kind assistance of Mr Paulson, because
without US government aid, Merrill (and Bank of America, for that matter) would have been bankrupt. I asked John about the ethics of awarding such bonuses to people who had just caused tens of
billions of dollars in losses, not to mention a world-historical financial crisis. His answer did not impress me.

A month later—in January, as usual—the rest of the investment banks announced
their
bonuses, which totalled about $19 billion. Paulson and Bernanke had neglected to attach any
conditions or compensation limitations to their assistance to the financial sector, which by that point totalled hundreds of billions of dollars. They also had neglected to take any steps to
address the rapidly rising tide of mortgage defaults, foreclosures, home repossessions, and unemployment. Their job was banks, not people.

CHAPTER 6

A
S ALL BANKERS (INCLUDING
crooked ones) will readily tell you, there is nothing more important to the health of the
financial system than trust and confidence.

It is therefore all the more disturbing that, since deregulation, no other major industry has broken the law so often and so seriously—behaviour, moreover, that is now rarely punished. For
the last quarter century even highly criminal behaviour has typically resulted at most in civil settlements in which the institution admits nothing, promises not to do it again, pays a
fine—and then promptly does it again. Rarely are individual executives even sued, or fined, much less criminally prosecuted. The fines are generally trivial, a minor cost of doing business,
paid by the institution, or frequently, by insurance. Thus, while the housing bubble and financial crisis contain the largest and most recent episodes of financial sector misbehaviour, they are far
from isolated.

Obviously there are many honest bankers, and even through the bubble and crisis the majority of all banking transactions were performed properly. People still deposited
their salary, paid their bills, used their credit cards; companies issued shares and bonds. At the same time, however, there has been a sharp increase in organized, high-level fraudulent behaviour
across a wide array of financial markets, ranging from consumer lending to high-end institutional trading. This now occurs on such a large scale, and with such frequency, that it can no longer be
dismissed as aberrant or exceptional. It is no exaggeration to say that since the 1980s, much of the American (and global) financial sector has become criminalized, creating an industry culture
that tolerates or even encourages systematic fraud. The behaviour that caused the mortgage bubble and financial crisis was a natural outcome and continuation of this pattern, rather than some kind
of economic accident.

It is also important to understand that this behaviour really is criminal. We are not talking about walking out of a store absentmindedly and forgetting to pay, or littering, or neglecting some
bureaucratic formality. We are talking about deliberate concealment of financial transactions that aided terrorism, nuclear weapons proliferation, and large-scale tax evasion; assisting in major
financial frauds and in concealment of criminal assets; and committing frauds that substantially worsened the worst financial bubbles and crises since the Depression.

This might seem like an exaggeration. It’s not. Let us now review 1) the growth of financial criminality and its declining punishment; 2) the nature, severity, and consequences of illegal conduct during the bubble and financial crisis; and 3) actual and potential responses to this conduct.

THE FIRST MAJOR
outbreak of deregulation-era financial crime came promptly after the Reagan administration’s deregulation of the
savings and loan industry. The S&L scandal established a pattern that has intensified ever since. Since the early 1980s, financial sector criminality has sharply increased,
particularly in investment banking and asset management, while prosecution and punishment have declined nearly to zero. People employed by major, politically powerful banks are almost never
prosecuted, and rarely if ever imprisoned, and there is a striking disparity in treatment of identical crimes as a function of the criminals’ institutional affiliations, or lack thereof. The
overwhelming majority of financial sector offences that are criminally prosecuted are committed by asset and hedge fund managers, by individuals who provide confidential information for insider
trading, or by individual investors. Thus Bernard Madoff, Raj Rajaratnam, and Martha Stewart are prosecuted; executives of Goldman Sachs, JPMorgan Chase, Citigroup, and even Lehman Brothers have
not seen similar charges.

The S&L, leveraged buyout, and insider trading scandals of the 1980s were the only ones for which significant numbers of politically powerful bankers were prosecuted. There were several
thousand criminal prosecutions, resulting in prison sentences for prominent and wealthy executives such as Charles Keating and Michael Milken. Even then, few prosecutions were directed at the core
of the financial sector, in part because it had not yet become highly criminalized. The worst offences, and most prosecutions, occurred in the industry’s periphery. Keating ran a West Coast
S&L that went bankrupt; Milken worked for Drexel, which had been a small, second-tier investment bank until his arrival. Even then, however, there were disturbing signs. For example, the very
well-established accounting firm Ernst & Young had failed to warn about massive accounting irregularities by its S&L clients and agreed to pay fines totalling over $300 million, and some
prestigious investment banks had worked for greenmailers and fraudulent S&Ls.

But it was in the late 1990s that, for the first time since the 1920s, the largest, oldest, and most important firms in finance went off the rails. The expansion and consolidation of the
financial sector in the 1990s, the Internet bubble, the rising power of money in national politics, and further deregulation together created an unprecedented
opportunity for
bankers to make money improperly, and some seized this new opportunity with astonishing enthusiasm.

On 7 November 2011, the
New York Times
published an article based on its own review of major banks’ settlements of SEC lawsuits since 1996. The
Times
’ analysis found
fifty-one cases in which major banks had settled cases involving securities fraud, after having previously been caught
violating the same law
, and then promising the SEC not to do so
again.
¹
The
Times
’ list, furthermore, covered only SEC securities fraud cases; it did not include any criminal cases, private lawsuits by
victims, cases filed by state government prosecutors and attorneys general, or any cases of bribery, money laundering, tax evasion, or illegal asset concealment, all areas in which the banks have
numerous violations. Here is a tour of some major cases.

ENRON, WHICH SUFFERED
the largest bankruptcy in American history, was the stock market’s darling in the late 1990s. Enron was also politically
well connected, particularly to Republicans. Based in Texas, it was a strong supporter of Governor George W. Bush. As noted earlier, its board of directors (and its audit committee) also included
Wendy Gramm, a former chairperson of the Commodity Futures Trading Commission and the wife of Phil Gramm, then the chairman of the US Senate Banking Committee.

Previously a staid energy pipeline company, in the 1990s Enron expanded into energy trading, bandwidth trading, and derivatives trading in order to cash in on the deregulation of electricity
production, telecommunications, and financial services. Enron’s operations were highly fraudulent, both financially and operationally, but the company continued to grow, with twenty-two
thousand employees at its peak. Enron faked its bandwidth and energy trading and artificially withheld electricity supplies to raise prices, behaviour that played a role in the severe electricity
shortages that plagued California in 2000–2001.
Enron also committed massive financial frauds to create artificial profits and to hide liabilities and losses.

But what was particularly notable about the Enron affair was that Enron’s frauds depended deeply on long-term cooperation from its accounting firm, one of the “Big Five”, and
also several of America’s largest banks.

In its financial frauds, Enron’s principal technique was to create off-balance-sheet entities known as SPEs, or special purpose entities, which it used to create fictitious transactions
that made streams of borrowed money look like revenues. In the years just before it collapsed in 2001, Enron’s earnings may have been overstated by as much as a factor of ten.
²
Some of the world’s best-known banks knew exactly what Enron was doing and lined up for the privilege of helping it perpetrate this fraud. They all did
basically the same thing—namely, create sham transactions to inflate revenues or assets.

Starting in 1997, Chase Bank, now part of JPMorgan Chase, helped Enron create false gas sale revenues. The transactions involved two fictitious offshore entities, both with the same nominal
director and shareholders. One of them, Mahonia, borrowed from Chase to “purchase” gas from Enron, for which it paid cash. The second, Stoneville, “sold” the same amount of
gas at the same price to Enron, and was paid with long-term interest-bearing Enron notes. Behind the smokescreen, Chase was making a loan to Enron and conspiring to make the loan proceeds look like
revenues. Over several years, the scam created $2.2 billion in fake gas revenues and associated profits.

Citigroup started doing the same thing in 1999, when Enron was trying to cover up a huge shortfall in projected revenues and cash flow. Citigroup agreed to help, and presto—Enron had
nearly a half billion dollars of new positive operating cash flow. Enron used this trick again and again, and the total fictitious trading cash flows appear to have been on the same scale as the
Chase Mahonia scam. Again, the record leaves little doubt that Citigroup knew what it was doing.
³

Finally, there was Merrill Lynch. Enron asked Merrill to buy two Nigerian power barges (yes, Nigerian power barges) at an inflated price—
subject to a handshake deal
that Enron would buy them back. Merrill may have had concerns about the transaction, but consciences might also have been eased by a 22 percent fee. Enron later tried to weasel out of the deal,
which prompted some screaming matches. Merrill eventually got its money back, although Enron had to construct
another
fake transaction to produce the cash. Almost simultaneously, another
Merrill team helped Enron with the purely fictitious sale and repurchase of a power plant. Nothing substantive had occurred, but Merrill got a very real $17 million fee for helping Enron create
fake revenues and profits.
⁴