Aaron Swartz, Financial Fraud, and the Justice Department

Many people have been asking about the Justice Department’s priorities in the wake of the suicide of computer whiz and political activist Aaron Swartz. As has been widely reported, the Justice Department was pressing charges that carried several decades of prison time against Swartz. He was caught hacking M.I.T.’s computer system in an apparent effort to make large amounts of academic research freely available to the public.

The Justice Department’s determination to commit substantial time and resources to prosecuting Swartz presents a striking contrast to its see no evil attitude when it comes to financial fraud by the Wall Street banks. People should recognize that this is not just a rhetorical point. It is clear that the Justice Department opted to not pursue the sort of investigations that could have landed many high level people at places like Goldman Sachs and Citigroup behind bars.

First, it is important to acknowledge that stupidity, not fraud, was probably the largest factor driving the housing bubble. In the years when the bubble was peaking, 2002-2006, I met many people with no obvious stake in lying who would tell me stories of how housing was always a great investment. The same was true when the stock market was selling at twice its historic valuations in the late 1990s.

Unfortunately, many of the people who control large amounts of money at banks, pension funds, mutual funds and elsewhere can be pretty clueless when it comes to understanding the economy. This mismatch of jobs and skills imposes large costs on the economy, but does not involve criminality.

However there clearly was a substantial component of criminality in the housing bubble, which the Justice Department has chosen not to pursue. Specifically, we know that large numbers of fraudulent mortgages were issued. The FBI publicly warned about an “epidemic of mortgage fraud” as early as 2004.

This was not an issue of people lying to qualify for mortgages; it was overwhelmingly a case of issuers putting down false information to give people mortgages for which they were not qualified. This could mean, for example, that a couple applying for a $400,000 mortgage accurately reports their income at $60,000. Since this income would be grossly inadequate, the bank issuing the mortgage changes the income number to $120,000.

I received numerous e-mails during these years from people telling me about friends or relatives working at major subprime lenders who were being told to change numbers so that people would be able to get mortgages for which they were not qualified. Unless there was a conspiracy to fool Dean Baker, this sort of practice must have been commonplace.

The way the Justice Department would prosecute this fraud would be to find some of the worst branches and put together a case against the worst loan officers. They would then offer them the option of substantial prison time or explaining why their supervisors were unconcerned about them writing in phony numbers on loan forms. When they have two or three loan officers to make a case against a supervisor, they then offer the supervisor the option or jail time or explaining how he/she decided that it was clever to have their branch office engage in mortgage fraud. It is impossible to say whether this sort of investigation would have nailed an Angelo Mozilo (the CEO at Countrywide), but there is no evidence the Justice Department even started down this path.

In the case of the investment banks, the questions would be directed at the people who packaged together tens of thousands of fraudulent mortgages in mortgage backed securities. Again, being fooled by someone who passed along a bad mortgage is not a crime, but making a decision to ignore all sorts of warning signals so that Goldman Sachs or Citigroup can securitize the mortgage is a crime.

The path here is the same as at the issuers. The Justice Department would go to the people putting together the mortgage backed securities, present them with the most bogus mortgages they placed in pools, and ask them if they really are dumber than rocks. Odds are that at least some of the hotshot Harvard MBA types would fess up that they had some clue that the mortgages were not entirely kosher. We can never know whether such investigations would have landed folks like Lloyd Blankfein and Robert Rubin behind bars, but if the Justice Department tried this route, they have not been anxious to talk about it.

By contrast, we do know that the Justice Department was willing to devote considerable effort to putting Aaron Swartz behind bars. While the point of financial fraud was to make the perps rich, Swartz was trying to make academic research freely available to the public.

Swartz may have broken the law with his actions. If he did, he broke the law in the same way that people selling blue jeans on the black market in the Soviet Union broke the law. In both cases the actions could be deemed harmful to a system that relies on archaic restrictions. In the case of the Soviet Union, a system of rigid central planning; in the case of the United States a horribly archaic and inefficient system of copyright protections.

The Justice Department apparently wanted to send a message with its decision to prosecute Swartz while ignoring the financial fraud that fueled the housing bubble. It certainly did.