[William D. Cohan] Ending the moral rot on Wall Street (Part 1)

The following is the first installment of a three-part article on Wall Street corruption and remedies for it. ― Ed.

What will it take for Americans to finally get the message that much of Wall Street, in its current form, is a corrupt enterprise in need of a top-to-bottom overhaul, a task that the year-old Dodd-Frank law, for all its verbosity, barely attempts?

There is ample evidence in the detritus left behind by the ebb tide of the worst financial crisis since the Great Depression. There are the thorough ― and thoroughly damning ― reports (along with thousands of pages of accompanying internal Wall Street documents) produced by the Financial Crisis Inquiry Commission and the Senate’s Permanent Subcommittee on Investigations. More was exposed by Anton Valukas, the chairman of the Chicago law firm Jenner & Block LLP, in his investigation of the accounting shenanigans engaged in by a handful of Lehman Brothers Holdings Inc.’s executives in the months leading up to that firm’s spectacular bankruptcy in September 2008.

Each examination revealed layer upon layer of behavior that should make us seethe with anger. These include the decision to manufacture and sell mortgage-backed securities that were stuffed with loans of questionable value, plus the worthless AAA ratings placed on them by ratings services paid by Wall Street to do so. Also the business model that encouraged bankers and traders to take asynchronous risk with other peoples’ money with the knowledge that by the time things went wrong, billions of bonus dollars would be paid out, and no effort would be made to hold anyone accountable.

Then there is the surfeit of lawsuits brought against Wall Street ― some since settled, some ongoing ― that add to our understanding of the deception. One example: the $550 million fine ― one of the largest ever ― that Goldman Sachs Group Inc. paid in July 2010 to the Securities and Exchange Commission. The penalty was assessed to settle a civil lawsuit questioning whether the bank provided enough information to investors about the efficacy of a squirrelly synthetic collateralized-debt obligation it manufactured and sold in April 2007, about four months after the firm had started to short the mortgage market with a vengeance.

Documents released along with the lawsuit showed that the bankers working on the deal, known as ABACUS-AC2007, questioned its efficacy. One of them, Fabrice Tourre, a Goldman vice president, wrote in a January 2007 e-mail that he was “standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstruosities!!! Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the US consumer with more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job ... amazing how good I am at convincing myself!!!”

In the same note, Tourre confided that there was “more and more leverage in the system ... the entire system is about to crumble at any moment ... The only potential survivor, the fabulous Fab.”

If this weren’t cynical enough, Goldman had by that time decided to make a huge proprietary bet against the mortgage market, while continuing to sell mortgage-backed securities to investors at 100 cents on the dollar. In 2007 alone, that short bet made Goldman almost $4 billion, almost a quarter of the $17.2 billion in pretax profit the firm made that year. Yet it didn’t disclose its short to the market until Oct. 4, 2007, well after the money had been made, and then only in an obscure letter to the SEC.

“During most of 2007, we maintained a net short subprime position and therefore stood to benefit from declining prices in the mortgage market,” the letter said. Apparently, there’s no crime in this kind of behavior. There should be.

Goldman wasn’t the only bank to display ethically challenged behavior. Consider the $154 million fine that JPMorgan Chase & Co. paid to the SEC in June 2011 for doing pretty much the same thing. Or look at the $75 million fine that Citigroup Inc. paid to the SEC in July 2010 for misrepresenting its balance-sheet exposure to mortgage-backed securities. Citi told investors it had $13 billion of exposure when it really had $50 billion.

Or there was the agreement by Bank of America Corp. in February 2010 to pay the SEC a $150 million fine to settle charges that it misled its shareholders to persuade them to approve its September 2008 acquisition of Merrill Lynch & Co. Inc. The bank failed to tell its stakeholders that Merrill had paid its employees billions in bonuses at the same time it was losing billions in income.

Had the truth been known, Bank of America’s shareholders might have voted to scuttle the deal. But the firm’s executives, as well as the federal government, didn’t want that outcome, so they kept silent, and the deal went through unaltered. The federal judge who approved the settlement ― after the amount was increased almost fivefold ― correctly described it as “half-baked justice.”

Then there is the still-pending civil lawsuit filed by Preet Bharara, the U.S. attorney in Manhattan, against a mortgage-lending unit of Deutsche Bank AG, accusing it of lying about the quality of the home loans it issued. The U.S. is demanding repayment of hundreds of millions in losses suffered by the government. The Deutsche Bank unit “indulged in the worst of the industry’s lending practices,” Bharara said.

There’s much, much more. Indeed, the word at many Manhattan law firms these days is that legal action related to the financial crisis is keeping litigation departments busier than at any time before.

By William D. Cohan, Bloomberg

William D. Cohan, a former investment banker and the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. The opinions expressed are his own. ― Ed.