One precipitating event is the failure of the huge bank bailouts to do much for the economy. “Lenders who receive public funds should use those funds to lend,” saidChristopher Dodd, the Senate Banking Committee chairman. He complained that banks are “hoarding capital” and buying other banks, rather than lending it.
The Bush administration had good reason not to impose strong restrictions on the recipients of bailout money; it had to find a way to recapitalize the banking system without putting a stigma on those that took the money. Strict requirements on how the money could be used would have scared away too many healthy institutions.
But the bankers should have known that there was a risk of backlash. Few Americans ever dreamed of making what most investment bankers took for granted. In a year when red ink is flowing, why should there be any bonuses at all for executives? Talk of the need to keep valued executives does not play well when those are the same executives who got the banks into this mess.
A functioning banking system is necessary for a modern economy to grow, but it is not sufficient. The bank bailout was not intended to rescue the economy, but that fact was not exactly emphasized by advocates.
Washington took longer than it should have to realize the depth of the economic troubles, treating this as an American credit crisis rather than the worldwide recession it was fast becoming. The bailout was the only action in town, and people not unreasonably assumed it was supposed to make life on Main Street better. It hasn’t, and that has roused resentments.
If public pressure rises to prosecute one or more bankers, there is the not-unimportant question of what charges could be proved. The bosses at Tyco stole from the company, and those at Enron put out false financial statements that violated accounting rules. WorldCom lied about the nature of its spending, and thus turned losses into profits.
In this mess, on the other hand, there is every indication that many top bankers did not understand the risks they were taking, and were stunned when the losses materialized. That may have been stupid — another reason to think bonuses are inappropriate — but stupidity is not a crime. As a federal judge wrote this month in considering claims againstCountrywide Financial’s officers and directors, “the federal securities laws do not create liability for poor business judgment or failed operations.”
But that same opinion, by Judge Mariana Pfaelzer in Los Angeles, offers a road map for any prosecutor who wants to make such a case, even if there is no proof that company executives knew their financial statements understated the losses and risks they were facing.
The Countrywide complaint, she wrote, presents “the extraordinary case where a company’s essential operations are so at odds with the company’s public statements that many statements that would not be actionable in the vast majority of cases” can form the basis of a complaint.
“For example,” she wrote, “descriptions such as ‘high quality’ are generally not actionable; they are vague and subjective puffery not capable of being material as a matter of law.”
But in this case, she said, the complaint claims “Countrywide’s practices so departed from its public statements that even ‘high quality’ became materially false and misleading; and that to apply the puffery rule to such allegations would deny that ‘high quality’ has any meaning.”
It should be noted that the judge’s opinion did not find Countrywide had violated securities laws. She just kept alive a suit claiming that the company’s executives had acted illegally when they falsely claimed to be following tough underwriting standards in making mortgage loans.
She was not making new law. Responding to the last banking crisis, the United States Court of Appeals for the Third Circuit rejected a bank’s puffery defense that had been accepted by a lower court judge. “If a defendant represents that its lending practices are ‘conservative’ and that its collateralization is ‘adequate,’ the securities laws are clearly implicated if it nevertheless intentionally or recklessly omits certain facts contradicting these representations,” the court wrote. “By addressing the quality of a particular management practice, a defendant declares the subject of its representation to be material to the reasonable shareholder, and thus is bound to speak truthfully.”
That opinion was written about what a bank said in 1990, shortly before its loan losses went through the roof and its stock price went through the floor. But it has a 2008 ring to it.
All these cases were civil cases brought by private parties. So far it is not clear that the Securities and Exchange Commission would bring a civil case on such routine-sounding puffery as claiming that lending practices are conservative and cautious, let alone that the Justice Department would file a criminal case with no more evidence of misconduct than that.
But if the anger against Wall Street grows large enough, that could change. The executives may not have understood how badly they were hurting their banks, but perhaps it can be proved they knew, or should have known, that claims of disciplined and high-quality lending practices were woefully wrong.
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