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Congress, Investigators Grapple With Reforming Wall Street

Friday, May 14, 2010

In recent weeks, a flurry of investigations has been launched by federal and state prosecutors and regulators probing the business practices of Wall Street firms during the housing boom. Up to now, only one major criminal trial has emerged from the housing crisis and the near of collapse of Wall Street -- and federal prosecutors failed to make the charges stick. In November of last year, two former Bear Stearns hedge fund managers were found not guilty of securities fraud by a jury in a federal criminal trial in Brooklyn.

Failure in that complex, high-profile trial could make prosecutors think twice about repeating the experience. But there’s another reason investigators may be wary about bringing another criminal case against a Wall Street firm and its employees. Just as the government reluctantly concluded that the banks were too big to fail, they may also worry that they’re too big to lose in court.

John Coffee, a securities law professor at Columbia Law School, argues that a criminal indictment against a financial firm often destroys it. "It seems strangely counterproductive to indict and risk the failure of the very firms that you saved with taxpayer money," he says. During the Enron fraud trials, accounting firm Arthur Andersen went out of business even though it was later found not guilty.

Coffee believes prosecutors may instead seek to change banking practices. The recent investigations suggest that banks had too many conflicts of interest, he says, and raised questions about whether some banks were designing products to fail, and even profiting from that failure. Rather than indict these firms, says Coffee, prosecutors are more likely to pursue an industry-wide settlement that will require banks to change structurally and reduce the conflicts of interest.

Just as important, the investigations are whetting the appetite for reform. "They're changing the public mood,” Coffee says. “And the public is informing Congress that they want stronger controls on investment banks."

Congress seems to be listening. In a surprising move yesterday, the Senate voted to end an industry practice that many believe fueled the housing crisis: the shopping around by banks for a new credit rating agency to get a safer rating on what was, in many cases, a risky mortgage deal.

Anne Mathias, director of research at Concept Capital, an institutional broker that provides research and analysis for investment managers, believes such a measure can attract bipartisan support. She says: "It becomes very difficult for Democrats and even some Republicans to vote to support credit raters, who are seen as the absolute dark evil forces behind a lot of the problems in the housing market and then in the economy."

At the heart of all these investigations, Mathias adds, is the nature of the fiduciary responsibility of banks to all their clients, and whether a bank helping to sell a financial instrument should make sure that it is suitable for the people who buy it and that the investors know everything about it. "Currently in the institutional market, those rules are really not there," Mathias says.

Instead, the operating assumption is that institutional investors know what they're doing and will conduct their own due diligence. In many cases banks are playing a market-maker role, just bringing buyers and sellers together. "They’re acting like the guy who rents out space for a flea market," says Mathias. "He doesn't care who comes to sell and who comes to buy. And he doesn’t control if what someone is selling for a very high price is actually a piece of junk. He just provides the tables and the yard."

Congress is now debating whether banks should be doing more.

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