Investigators Won't Touch Wall St. In Subrime Mess

Ever heard of Sky Capital? Probably not. The CEO of that rinky-dink Wall Street firm and five of his employees were indicted this week over what the Securities and Exchange Commission described as a "trans-Atlantic boiler room scheme" to defraud investors. Maybe you have heard of Angelo Mozilo, the perpetually tanned former head of Countrywide Financial who faces civil fraud charges that he and two others knew many of their subprime loans were "toxic," as Mozilo allegedly described them in e-mails. Mozilo says he's innocent. Prosecutors believe he was one of many middlemen who fed one of the greatest confidence games of all time—the subprime-mortgage-backed securities scam—perpetuated by Wall Street.

But if you think this is ultimately going to be like the 1980s, when Wall Street's not-so-finest were cuffed and marched off to jail in front of the TV cameras, think again. Despite much fanfare a year or so ago from the FBI and the Justice Department, which said they were investigating major financial firms, most of the cases you are likely to hear about will be small fry like Sky Capital (whose executives have pleaded not guilty). The truth is, even the outcome of the Mozilo case is in doubt, according to legal experts.

Two years into the catastrophe, there have been almost no indictments beyond low-level mortgage-fraud cases. Yes, ample evidence exists that senior executives on Wall Street knew, or should have known, that fraudulently inflated home values, wholly invented incomes, and other illegal schemes figured in a huge percentage of the subprime loans that were turned into securities and sold around the world, according to prosecutors, county and state officials, and real-estate experts I have interviewed. And there are e-mails indicating some of these executives were privately worried that the boom might end, even as they evinced confidence publicly. But they all share a common defense: ignorance of just how bad things would get, says Carl (Chip) Loewenson, a former assistant U.S. attorney who helped prosecute some of the big insider-trading cases in the '80s. "So many of the big banks and investment banks had a very similar experience," says Loewenson, who now helps run Morrison & Foerster's white-collar defense unit in New York. "Look at Lehman, Merrill, Citi, Wachovia … They just got killed. Unless you're going to say they were all in one big conspiracy, or they all coincidentally happened to have identical conspiracies, the only reasonable explanation is they all got blindsided by a thousand-year storm."

The biggest case to date, the indictment of two former Bear Stearns hedge-fund managers, goes to trial this fall. That case is largely based on e-mails allegedly suggesting that the fund managers, Ralph Cioffi and Matthew Tannin, were also saying one thing to each other and another to investors. But according to lawyers familiar with the case, the government is going to have a tough time proving the fraud charges. Because their hedge funds were the first to implode, in the summer of 2007, Cioffi and Tannin were swiftly targeted by authorities and indicted in June of the following year. But that was before just about every other big firm blew up in the fall of 2008, adding credibility to the duo's defense that they could not have known market confidence would collapse and their repo financing would pull out overnight.

Tony Accetta, a former prosecutor in the U.S. Attorney's office in New York, contends the big Wall Street players know far more than they are admitting. For years before the subprime market collapsed, he says, they got in the habit of "netting," which means quietly swapping defaulted loans for good ones for favored investors—and selling securities that are not as good as you say they are is, on its face, securities fraud. "The criminality lies in the fact that the investment bank now knows that a substantial portion of mortgages are going to go south," says Accetta. "Putting them into securities without disclosing the high probability of default is aiding and abetting mortgage fraud." Indeed, there is a good case to be made that while many parties were to blame—including overextended borrowers—in the final stages of the bubble, Wall Street was largely responsible for much of the bad lending. The investment banks were so desperate for more mortgage-backed securities to sell that some of them cut deals with the big nonbank lenders to deliver billions of dollars worth of loans a month, no questions asked. "It's like drugs." Jim Rokakis, the treasurer of Ohio's Cuyahoga County, which was particularly hard hit, told me last year. "The police don't really want the small-time drug dealer or user. The guy they really want is the drug lord in Colombia. In this case, the drug lord was Wall Street. This was money looking for people to exploit."

But Loewenson says a failure to understand the real risks will be the "recurring theme" of the defense in all such cases. "Throughout the system, all the participants either didn't understand the risk or didn't value the risk from the borrowers," he says. "The underwriters were not doing a careful job, the rating agencies were not putting right ratings on things. The investors who were buying the securities didn't understand them."

The sad irony is that in pleading collective guilt, most of Wall Street will escape whipping for a scheme that makes Bernie Madoff's shenanigans look like pickpocketing. At the crest of the real-estate bubble, fraud was systemic and Wall Street had essentially gone into the loan-sharking business. It was no accident that in prison yards in Chicago, drug dealers were beginning to realize that with RICO investigations and other probes making narcotics an increasingly risky business, mortgages were a much safer business. Or that in New York, Russian gangs were buying legitimate mortgage-broker shops to get in on the action, according to law-enforcement officials. Fraud in loan documents became so commonplace that "people forgot it was wrong," says Patrick Madigan, an Iowa assistant attorney general who helped to negotiate a $325 million settlement in 2006 over alleged abuses by Ameriquest, the nation's largest subprime lender. "If you view something every day, day after day, and the guy sitting next to you is doing it, then sooner or later you're going to forget that falsified appraisals or boosting values on homes is wrong," Madigan says. The same goes for the securitizers on Wall Street.

And now even the concept of corporate fraud is being called into question by the highest court in the country. Last month the Supreme Court decided to hear the appeal of media mogul Conrad Black, who is serving a 6½-year sentence in a Florida prison for mail fraud and obstruction of justice. The case is unrelated to the subprime issue, but the legal theories overlap. Black's lawyers contend that he was unjustly convicted on the hazy notion that he had merely failed to render "honest services" to his shareholders. A number of the Enron convictions have been overturned on similar grounds.

Unfortunately, prosecution of fraud is "the only way you're going to get reform" on Wall Street, argues Accetta. Going after small fry like Sky won't do anything to deter future scamming by the Street. "This is a systemic problem that goes back to the dotcom bubble, to the Enrons, HealthSouths, and Worldcoms," he says. "Our corporate capital-formation structure for the last 10 to 15 years has gone beyond the odd-duck crook here and there. It's become institutionalized."