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In Banking World, Fraud Is an Epidemic

AIG headquarters in New York City. (Image via Wikipedia)

Part of the Series

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Reason to be afraid #6:

Systemic corruption and a fundamental conflict of interest are driving us toward the precipice of new economic crises.

In the early spring of 2010, my phone rang, and the caller ID read “Unknown.” On the other end of the line was an AIG whistleblower. Until the 2008 financial crisis, AIG was a rogue elephant in the zoo of the US financial world, unknown to most Americans. After that, though, everyone who read a newspaper knew what AIG was. AIG Financial Products Division (AIG-FP), the London-based unit that took on the risk for the Wall Street banks, became a familiar villain in the developing story of fraud and corruption underlying the Great Recession of 2008–2009.

My caller spoke tentatively at first, without specifics, as cautious whistleblowers do, but she was concerned about the way in which the AIG compliance office at corporate headquarters worked. This was the office responsible for ensuring that the huge insurer did not break the law in any one of the 145 or so countries where it operated.

According to the caller that morning, the mainstay of AIG’s compliance program was “a joke,” and it had been for a long time. For years the program consisted mainly of a list of about four hundred email addresses for compliance and law enforcement officials around the world, many of which were defunct (either the addresses, the officials, or both). Whenever AIG wanted to inform the offices abroad and their government counterparts of a new legal or ethical obligation, AIG Compliance would blast out the news using this listserv. Then the office director would order the deletion of the plethora of bounce-backs and consider her mission accomplished.

Every source said that anyone who tried to notify the AIG corporate board about compliance problems before 2008 found him – or herself on the post–September 2008 redundancy list.

Over the next few weeks, we started getting names and numbers of other sources at AIG who would validate the fact that much of the compliance work there was substandard, leading up to and away from the weekend in September 2008 when the financial captains at the helm of the banking world finally realized they had steered it off a cliff. The AIG allegations we heard were awful, and the people who made them were afraid to have their names used in any public way. All of the claims hung together, though. One corroborated another. And the charges were quite specific.

Everyone I talked to mentioned James Cole, who worked in the office as an independent consultant for the SEC. He was positioned in the compliance office, went to AIG board meetings, wrote reports, interviewed people, and generally hung around. The Wall Street Journal reported that this assignment earned his law firm, Bryan Cave, around $20 million, for about five years work.

Sources at AIG pointed out that an independent consultant/ monitor for the SEC in the compliance and regulatory office was a condition of a deferred prosecution agreement that AIG struck with the SEC, the Bush administration’s Department of Justice, and the New York State Department of Insurance to settle allegations of aiding and abetting securities fraud dating back to 2000. At the time, deferred prosecution agreements (DPAs) were typically used to deal with low-level narcotics cases, and the New York Times called the agreement “somewhat unusual in white collar cases.”

Under the terms of the DPA, AIG paid a fine and appointed Cole to report to the SEC and the Justice Department on compliance. In this position, he reviewed the dubious financial transactions from 2000 forward, structured by AIG that supposedly violated accounting regulations and securities laws. These transactions were developed and handled by AIGFP PAGIC Equity Holding in London, headed by Joseph Cassano. At the time, Cassano was also the also the head of AIG Financial Products Corporation, the unit that sank AIG, its banking counterparties, and the US economy in 2008.

Then US deputy attorney general Eric Holder established the first guidelines relevant to DPAs for corporations in 1999 in a document that came to be known as “the Holder memo.” In the years since then, the memo has been criticized for its failure to address the DPA scenario specifically and the nebulous standards it set out. Among other things, the Holder memo failed to define compliance or to specify the requirements for selecting external monitors of corporate governance. The lack of definition caused great power to default to prosecutors, and left the door open to more and more flexible DPAs. These agreements have increased in number substantially, surging to thirty-eight in 2007, up from four in 2003.

Despite Cole’s monitoring after 2004, AIG was once again in trouble with the SEC and the Justice Department by 2006. The corporation faced charges of additional financial improprieties and bid-rigging but settled with a second DPA, despite the fact that one of the factors applied to assess eligibility for a DPA under the guidelines of the Holder memo is the lack of an earlier offense. Under the 2006 agreement, admittedly, the fine was much stiffer than that exacted in 2004: AIG paid $1.6 billion in 2006 and broadened the scope of Cole’s monitoring authority. At that point he became responsible for examining AIG’s controls on financial reporting as well as corporate governance in the compliance area. In exchange for this deal and the two payments, the charges against AIG were resolved two years before AIG-FP was identified as the epicenter of the 2008 financial cataclysm.

As the AIG monitor, Cole was to file reports with the Justice Department and the SEC. The reports, which were pages and pages of nothingness, were secret, but we obtained those Cole filed with the SEC. They were not for public consumption even in 2010, when the American public owned AIG, or 90 percent of it. Also, in light of what had happened there, the fact that Cole’s reports to the SEC in 2006, 2007, and 2008 were uniformly basic and abstract was important in itself. In August and September 2007, he issued 215 pages of stupefying, mundane recommendations that read as if they came directly from a fraud examiner’s manual somewhere. There was no meaningful interpretation, no analysis of how the law applied to AIG, even in the United States, never mind how it might affect overseas operations. There was no review of the corporation’s actual practices, nor of the adaptations required to ensure that the crimes addressed in the DPA did not recur. The whole job looked like a cut and paste, until page eight-seven of the September 30 report. There, Cole wrote:

The Derivatives Committee [of the AIG Board] should be responsible for providing an independent review of proposed derivative transactions or programs entered into by all AIG entities other than AIG Financial Products Corp. (“AIG-FP”).

He elaborated this exemption further:

For derivative transactions or programs entered into by AIG-FP, the appropriate independent review of the proposed derivative transactions or programs should be conducted by AIG-FP.

If AIG-FP reviews AIG-FP’s transactions, though, that isn’t really an independent review, is it?

When Cole wrote this waiver in September 2007, we were just under a year away from the awful night when the credit markets froze in the United States because no one knew which, if any, of the commercial and investment banks were solvent. Technically, many of them were not; their huge trades in derivatives, based on MBSs then going bad, were insured by AIG-FP, and AIG, for its part, lacked the reserves to pay out on the worthless positions the unit had guaranteed. In the wake of the 2008 economic collapse, press attention turned briefly to Cole, but no information was forthcoming from him, and no one other than the principals ever saw Cole’s reports to the Justice Department.

It got worse. One night in May 2010, about 9:00 p.m., the AIG source called again in an audible state of shock. James Cole was about to be nominated by President Barack Obama as deputy attorney general (DAG) of the United States, she said. The DAG is the senior official at the Justice Department who is often responsible for the decision to prosecute in a particular case, based on initial investigations. At GAP the next day, we were incredulous. The information was correct. Obama announced Cole’s nomination as the second in command at the Department of Justice.

The Senate refused James Cole a vote on confirmation all through 2010, the longest delay of a DAG confirmation in thirty years. Obama was determined to have Cole, however, and so, reportedly, was Attorney General Eric Holder, a long-time friend and fellow poker player. The president gave Cole a recess appointment on December 29, 2010. He was sworn in on January 3, 2011, was finally confirmed by the Senate the following year and continues to serve.

The lack of criminal prosecutions coming from the Justice Department in the aftermath of the financial crisis is remarkable.

The lack of criminal prosecutions coming from the Justice Department in the aftermath of the financial crisis is remarkable. It is, in fact, a glaring lack of zeal on the part of Justice. Consider, for example, US attorneys’ prosecutions in the past five years: Tom Drake and John Kiriakou found themselves under criminal indictment, but the bankers and derivatives traders seemed beyond the reach of law enforcement.

On the 60 Minutes episode that featured Richard Bowen in December, 2012, Lanny Breuer, head of the Criminal Division at Justice then, tried to explain this apparent immunity. The response he gave was both condescending and transparently untrue. Breuer insisted that the department prosecuted cases it seemed likely to win, and he pointed out that the standard of proof in a criminal case is high. Therefore, in many cases where wrongdoing was evident, it made more sense to reach a civil settlement than to try a criminal case and lose.

Justice couldn’t make the case against Tom Drake, either though, and yet US attorneys prosecuted him. They were forced to drop three of four charges against Kiriakou, but they still brought them. The high-profile prosecution extravaganza directed at the wretched former presidential candidate John Edwards is also notable. Justice lost that one, too, but the department evidently decided to waste years of time and buckets of money on that. Clearly, there is something more than “winnability” involved in the prosecution selection process going on at Justice.

Attorney General Holder explained more candidly when he sat before the Senate Judiciary Committee under oath on March 11, 2013. There he admitted:

I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them when we are hit with indications that if we do prosecute – if we do bring a criminal charge – it will have a negative impact on the national economy, perhaps even the world economy. I think that is a function of the fact that some of these institutions have become too large.

For Holder this was well-plowed terrain. He had struggled with the issue of indicting corporations since writing his 1999 memo on prosecutorial guidelines for avoiding such legal conflicts. The memo was an early effort to find a way to reform corporate compliance and ethics practices without resorting to criminal charges and shutting down the company with its attendant impact on jobs and the economy.

One year after Cole, on behalf of the SEC, exempted AIG-FP from independent review of its derivatives trades, the US economy faced imminent collapse. On Monday morning, September 15, 2008, Lehman Brothers filed for bankruptcy protection: on that particular day, the firm held more than $600 billion in debt, much of it owed to other interconnected financial institutions. The effect was dramatic. Less than forty-eight hours later, money markets were approaching paralysis, and banks, at that point highly leveraged and heavily dependent on overnight borrowing from these same purportedly risk-free funds, faced the prospect of illiquidity, unless the Federal Reserve stepped in to back them, which it did.

Shortly after Lehman failed, of course, AIG experienced its own crisis: the corporation saw a precipitous decline in the value of its credit default swaps. These were contracts that allowed investors to bet on the credit worthiness of debt based, to a large extent, on subprime mortgages. Among the largest bettors were major Wall Street banks, and AIG was massively exposed. Then, despite the various bailouts and the frantic machinations of Treasury and the Federal Reserve, the economy of the United States truly began to unravel.

It was very important that callers and emailers could be fairly certain their identities would be protected. They were communicating confidential information, yet that information was essential to the public interest.

At the time of the financial crisis, the operators of the nation’s critical infrastructure – which we would have to say includes AIG – were not yet officially authorized to scan their employees’ personal communications and their customers’ data for the purpose of supplying it to the NSA. In the two years that followed all this, people phoned and emailed us at GAP with information about what had really happened inside AIG. Senator Charles Grassley also received crucial information about AIG from whistleblowers. It was very important that callers and emailers could be fairly certain their identities would be protected. They were communicating confidential information, yet that information was essential to the public interest. In some calls to us, whistleblowers were exploring the possibility of legal representation in the event that it became necessary. If they had been readily identified, they could have been subjected to ruinous retaliation, and as a rule, the more serious the disclosure, the more vicious the reprisal.

Under CISPA, AIG would have found the whistleblowers, and not only that: they would have no legal remedy to address whatever reprisal AIG visited on them next.

One of the initial calls from the first AIG whistleblower was from a personal cell phone to a land line, and the whistleblower gave me additional names and numbers to call for more information about the bogus AIG compliance program. This information was not strictly protected by nondisclosure agreements, but the allegations made were unfavorable to AIG, a firm that undoubtedly would be covered by CISPA as it is written. Callers described and documented incompetence, racial discrimination, lack of due diligence, parasitic and redundant contracts, cronyism, retaliation, and so forth. Management at AIG would have every incentive to hunt down the identity of that first caller. Over the ensuing months, I received at least fifty emails from her after hours – from her personal email account to my GAP account. Someone employed at an institution deemed critical to the nation’s financial infrastructure was exposing improprieties in the firm’s compliance office to an outside organization. Under CISPA, AIG would have found the whistleblowers, and not only that: they would have no legal remedy to address whatever reprisal AIG visited on them next. If telephone metadata for my cell phone were collected by the NSA and delivered to AIG, the corporation would have a comprehensive list of its best-informed critics.

The collaboration between government power and corporate wealth is already finely tuned, as the experience of the unfortunate Eliot Spitzer and the DPAs themselves show. If we allow it to become closer still, we will be losing whatever legal protections remain for the dissenters and whistleblowers who survive among us.

As the financial crisis deepened, however, the bailout itself created a profound conflict of interest for the US government that is unresolved even now.

The bailout of 2008–2009 was successful in a sense. It averted an economic recession/depression much worse than the one that actually occurred. As the financial crisis deepened, however, the bailout itself created a profound conflict of interest for the US government that is unresolved even now. A number of analysts, economists, and accountants pointed this out in late 2008 and early 2009, but no one who mattered paid attention. The Treasury Department owned a majority stake in AIG, which the government would, at some point in the short or medium term, sell back to private investors. Would it make sense for Treasury, now the owner of this corporation, to reveal to the public – and thus to the market – that the compliance program at AIG was worthless?

No. It wouldn’t. And Treasury was under enormous pressure. Populists in the United States, both on the left and right, opposed the bailout as a giveaway to financial institutions, so Treasury simply had to come out of the crisis without a substantial loss. Although this was manageable, of course, the processes behind it weren’t credible. The Treasury Department was both the owner of the compromised banks and their evaluator. This conflict of interest leaves us unsure about the validity of the stress tests applied to the major financial institutions in February 2009 to determine their capacity to withstand a difficult economic environment. The administrator of the tests, the US Treasury, had a very specific interest in the outcome. The department would sabotage its own interests if it were to announce to the market that the shares it intended to sell of Citi, Bank of America, JP Morgan Chase, and others were junk.

At the time the government bailed out US financial institutions in 2008, a number of politicians, activists, and interests expressed different objections. For taxpayers, it was galling that the same corporations whose greed and recklessness caused the crisis would be financially revived with public money. During the years previous, the bank managers, board members, and traders at fault compensated themselves with lavish salaries and bonuses, spoke with contempt about the average investor they defrauded, treated the capital markets like casinos, and generally lived large. Despite the popular resentment and anger at bankers and traders, though, between the administrations of Bush and Obama, the American government salvaged the wreck of Wall Street.

In doing so, they created a snare of conflicts of interest that has yet to be untangled. Many have been scrutinized and publicized since then. Some are simply an outrage in a country where competitive markets operate at all. The issues are numerous and complex, but the fundamental structural conflict of interest – the one illustrated by what happened to Richard Bowen, as well as by the positioning of James Cole – is unaddressed.

When the Treasury Department devised the Troubled Asset Relief Program (TARP), it acquired substantial ownership stakes in Citigroup, JP Morgan, Wells Fargo, Merrill Lynch, Morgan Stanley, Goldman Sachs, Bank of New York, and State Street Bank. Under a separate agreement, the US government acquired a 90 percent ownership stake in AIG. After the bailout, Treasury was to resell the shares it owned on the open market and recover for the taxpayer the hundreds of billions in cash and guarantees disbursed and committed in 2008 and 2009. To a large extent, the plan worked. The financial world stabilized and, at least partially, recovered. According to Treasury, as of June 2013, 96.1 percent of the TARP funds had been repaid.

This is a great success for the Treasury Department, the Federal Reserve, and for those who devised the TARP. The unfinished business, however, concerns law enforcement and systemic corruption. In order to resell the questionable assets acquired during the bailout, Treasury needed to ensure that the reputations of the corporations whose stock went on the market (and their officers) remained unsullied. The department could hardly sell its ownership shares of the banks or of AIG at par or better if the Justice Department were prosecuting directors, managers, or the corporation itself. Moreover, Treasury’s sales would be most beneficial to the government (and the taxpayer) if all legal liabilities were settled without an admission of guilt. We can hardly be surprised, then, that no high-visibility prosecutions of megabank officers materialized. Nor should we be surprised that the civil settlements brokered by the SEC and the Justice Department typically concluded without either an admission or a denial of wrongdoing by corporate officers.

Faced with systemic fraud in the financial and nonfinancial institutions that it owns, the Treasury Department will discourage the Justice Department from prosecuting.

When the bigger picture clicks in, it all makes sense. Faced with systemic fraud in the financial and nonfinancial institutions that it owns, the Treasury Department will discourage the Justice Department from prosecuting. If cases of corruption and fraud had been marginal or isolated to a few divisions in a few corporations, they could have been addressed and corrected. Specific culpable managers could have been identified and prosecuted, but this was not an isolated occurrence. The fraud was systemic. It was not contained in a single institution, either. It affected the financial industry as a whole. Fraud was and is epidemic. No single bank could opt out of it. If, say, one bank went straight, it would show lower returns, capital would flee, the CEO would be terminated, and another one who could get it right would be appointed.

The government in 2009 owned a substantial part of this industry. How could prosecutions of the industry’s officers benefit anyone? Because the fraud was institutional and integral, criminal prosecution would expose the fragility of the entire structure of finance. Jobs, mortgages, pensions, 401ks, and major fortunes could all have been devastated. Difficult as it might be to imagine, the damage might have been much, much worse.

We can debate whether Treasury should have done what it did in 2008 and 2009 all day long. It doesn’t matter much now. As Allen Blinder shows in his book, After the Music Stopped, Geithner, Bernanke, and Paulson did not have other options. They had to use the authority and machinery of the state to reclaim an economy on the verge of a breakdown – more accurately, in the wake of a breakdown. What is imperative, however, is that they stop misleading us now about the economy and begin – at least – to break up the banks (and AIG) so that this does not happen again. Instead, the cover-up continues. It is ongoing still.

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