Why Nobody Went To Jail For The Great Financial Crisis

On the tenth anniversary of the bankruptcy of Lehman Brothers, the media is full of articles questioning why nobody went to jail for the Great Financial Crisis that followed. Take, for instance, A crisis nobody went to jail for.

According to most of these articles, the GFC happened beause of greed, laziness, cronyism and cheating by banks.

We can straight away toss out greed, laziness and cronyism – they’re not crimes.

While cheating is a criminal offence, banks and financial institutions are arguably not guilty of this charge.

According to Michael Lewis’s bestseller “The Big Short” and many other accounts of the GFC, this is what happened:

Mortgage originators wrote home loans to Americans eager to achieve the “American Dream” of home ownership, FIs packaged the mortgages into Mortgage Backed Security and sold it to other FIs, who packaged MBS into Collateralized Debt Obligation and sold it to some other FIs, who packaged CDOs into CDO-square, and … .

On and on it went and loans were packaged into more and more fancy structured financial products and sold by one financial institution to another. It was product innovation at its best.

Borrowers were happy because they could buy bigger houses. FIs were happy because they earned fat fee income at every stage. Business was booming.

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According to the popular narrative, financial institutions hid the toxic nature of their assets. But that's simply not true. Instead they disclosed the exact composition of their structured financial products to Credit Rating Agencies. They needed to do this in order to get their products rates, which was a a prerequisite for selling them to other financial institutions. If anything, banks revealed too much, not too little. CRAs gave these products AAA or AA ratings, probably because they missed what Malcom Gladwell called “the sleazy stuff in footnote 42” of the applications forms they received from banks.

In hindsight, these products deserved junk-grade ratings. But, at the time, buyers had every incentive to take the AAA and AA ratings at face value because they could repackage whatever they bought into another product and sell it along to the next guy in the chain. It was like a game of “passing the parcel” – nobody stops to inspect what’s in the parcel lest the music stop when they’re still holding the parcel. In other words, no one wanted to be caught holding the package when the music inevitably stopped.

It was only when overextended borrowers (9% of the total) started missing their repayments years later that these originally-pristine products started turning toxic.

Banks might have exhibited a blithe attitude, but that’s not a crime. (Apparently some banks colluded with valuation agencies to inflate the price of homes. That’s a civic - not criminal - offence and many banks did get fined for that. More on that in a bit).

(https://twitter.com/s_ketharaman/status/1041695543930564609)

While CRAs were guilty of incompetence in giving high ratings to these products, incompetence is not a crime, either. It’s also perhaps a testimony to the intrinisic complexity of the task of rating that the same CRAs enjoy 94% share of the ratings market ten years later.

While all this was happening, a few finance industry honchos like Dr. Michael Bury and Steve Eisman pored over the aforementioned prospectuses and spotted the toxic ingredients in the MBSs, CDOs and CDO2s. They rightly predicted that the music would stop imminently and shorted the subprime mortgage market. When their bets proved right, they made a killing.

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As for chances of a similar crisis happening in future, Wall Street banks just launched even fancier synthetic products based on Bitcoin. There’s still no law to stop them from packaging these products and selling them to one another the way they did last time. So the powder keg is already in place.

What's missing is the spark. Probably in the interest of political correctness, the media conveniently ignores the role of the consumer in the last GFC. It was the consumer who borrowed more than his or her ability to repay (which is also not a crime). It was the consumer’s default in repayments that set off the whole chain of events that eventually precipitated the last crisis.

Unless the common man takes greater responsibility for their financial actions, I’m afraid, sparks will fly soon.

I’m not alone. Fortune predicts the same in its recent cover story entitled The End is Near. In another piece titled How to Spot the Next Financial Crisis, the magazine observes, “The main causes of the last crisis—human self-delusion and irrationality—will be the main causes of the next one. If that seems unbearably depressing, cheer up: It tells us what to watch out for.”

The last crisis was undergirded by physical assets in the form of homes. The next one, if and when it happens, will  have 1s and 0s floating around in cyberspace.

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Contrary to the popular narrative, one person actually went to jail for GFC: Kareem Serageldin, former Managing Director / Global Head of Structured Credit in the Investment Banking Division of Credit Suisse Group. According to Wikipedia, Serageldin “was sentenced to 30 months in prison in connection with a scheme to hide more than $100 million in losses in a mortgage-backed securities trading book at Credit Suisse.”

But, since he was a midlevel functionary in a tier two financial institution, you might still think the industry got away lightly.

That’s not entirely true. According to Wall Street Journal, the six largest US banks have paid at least $110 billion in penalties related to the crisis.

So they didn't get away scot-free, after all.