Unfair and Unnecessary Legal Settlements are Hurting the Banks

By Roy C. Smith

Morgan Stanley recently agreed to pay $2.6 billion, about 42% of its 2014 earnings, to settle federal claims that it had deceived investors by misrepresenting the quality of the home loans that were packaged into mortgage-backed securities in the years preceding the 2008 financial crisis.

All of the major US capital market banks have been involved in similar settlements, which are paid by shareholders, not by individual wrongdoers.  

There is no precedent for all of the principle competitors in an industry being the subject of such lawsuits. Altogether the banks have paid more than $130 billion to settle charges of misconduct in a variety of areas before, during and after the financial crisis.  Several additional investigations that could lead to further settlements are ongoing.

The settlements certainly leave the impression that the banks must have done a lot of terrible things to have to pay out so much money.  Apparently the Federal Reserve thinks so: Janet Yellen, Chairman of the Federal Reserve, and William Dudley, President of the NY Federal Reserve Bank, have recently referred to the settlements as evidence of unacceptable “cultural” deficiencies that could affect the banks’ “safety and soundness,” and impose “systemic risk” that could threaten the financial system. If not addressed, they say, these cultural problems could require regulators to curtail some of the banks’ activities, or break them up.

In the long history of bank regulation prior to the financial crisis of 2008, cultural deficiencies have never been mentioned as a reason for regulatory intervention, nor have banks as corporate persons been sued for the misconduct of employees. 

So, this time is different. But what, exactly, did the banks do to justify such penalties?

Actually, there is no way to know.

There have been no trials requiring the presentation of evidence and a verdict by a jury. With few exceptions, the settlements have not included admissions of guilt, and all the case files have been sealed.

Though Morgan Stanley was the latest to do so, most of the major capital market banks have settled charges related to mortgage-backed securities before 2008.  Morgan Stanley bought subprime mortgages from New Century Financial Corporation, the country’s second largest subprime mortgage lender and a NYSE listed company that filed for bankruptcy in 2007.  Like the other banks, Morgan Stanley securitized the subprime mortgages it bought into mortgage-backed securities, obtained bond ratings from Moody’s and Standard & Poor’s, and then underwrote and sold them under rules for public offerings enforced by the Securities and Exchange Commission to knowledgeable institutional investors.

A different lawsuit filed in 2012 provided emails suggesting that Morgan Stanley employees were aware of the low quality of the mortgages they were buying from New Century.  Most of the other cases have reportedly had similar email evidence.

However, purchasing low quality subprime bonds was not illegal. Indeed, they are the rough equivalent of “junk” bonds (rated below “investment grade”) that have been widely distributed in securities markets since the 1970s. Their lower credit quality, reflecting a higher expected default rate, requires a higher interest rate than is offered for higher-grade securities.  Having a difference enables investors to choose the risk/reward package they want. Almost all investors in mortgage-backed securities are experienced professional investors aware of the risk contained in subprime mortgages.

The new issue process is extensively regulated and involves several layers of due diligence performed by independent parties. It is, as it is supposed to be, difficult, for any single party in the process to misrepresent the quality of the securities being offered.

Misrepresenting the quality of the bonds (or the mortgages or collateral to which they were tied) in the offering prospectus or disclosure memo would have been a violation of federal securities laws. Those injured by violation of the securities laws are entitled to bring civil suits against banks causing the injury.  However, the Morgan Stanley case (like most of the others) was brought by the Justice Department, not by a plaintiff experiencing a loss, or by the SEC.  Only the Justice Department can bring criminal cases involving federal securities laws, so the presumption is that if the settlement was with the DOJ, then the case that it might have brought would have been criminal.

Charging a bank with a criminal offense changes everything.  Banks have to hold licenses, which may be withdrawn if the banks’ owners (holding companies) become convicted felons. Losing a criminal case, even if a bank’s defense is solid, would be disastrous for a major banking or financial services company. Arthur Anderson, a major accounting firm lost its licenses after being convicted of destroying evidence in a criminal case related to Enron in 2002, and was forced into bankruptcy.  The Supreme Court subsequently overturned the conviction, but by then it was too late to save Arthur Anderson.

No board of directors of a major bank has been willing to face a trial in a criminal case, and according have invariably instructed their managers to settle such cases instead.  So threatening a criminal suit assures that there will be a settlement, the only question being for how much.  The DOJ seems to base settlement amounts on how much a bank can afford to pay, rather than on any assessment of damages done.

The Justice Department has preferred to sue banks rather than pursue individual officers or directors suspected of wrongdoing.  Substantial investigations have occurred but no person in an executive position of responsibility has been charged with any offense, because, as some prosecutors have said, they did not uncover sufficient evidence to secure a conviction.

If there is not enough evidence to convict an executive in authority, what evidence is there likely to be to convict the bank as a corporate person?

Logically, you might think none. But prosecuting corporations is a different matter. What prosecutors have to establish, according to DOJ guidelines, is that the corporation did not do enough to prevent fraud or other misconduct from occurring, or to detect and halt it when it did, or to cooperate with the government in bringing charges against responsible individuals.  These are different things to establish in court, but the DOJ has not had to do so because the cases were settled, not tried.

The process of threatening banks with criminal charges when no responsible officer or director can be found is a form of bullying that turns them into low hanging piñatas. The suits are not necessary to improve bank safety and soundness, and actually work against those objectives by diminishing the banks’ capital. They only serve as punitive measures to a population (shareholders) that has already paid in decimated stock prices, low returns on equity and a slow recovery to the way things were.

Of course, prosecuting unpopular banks has also had political benefits for the Obama Administration and for a number of state attorneys general.

Regulators like the Federal Reserve know more than most about bank activity and behavior, and accordingly want to force banks to improve their management and control functions. Since 2008, all the major banks have been attempting to do this, but they and their cultures have also been required by Dodd Frank and other new regulations to double capital requirements, halve leverage, maintain twice as much in liquid assets, drop out of certain businesses, and pay the $130 billion in settlements.

As a result the return on shareholder equity for all but one of the largest originators of capital market activity in 2014 (and for several prior years) was no better than, or in ten cases among the top twelve global capital market banks, much less than their cost of equity capital.  The Economic Value Added of the capital markets industry is currently less than zero, suggesting that the whole industry may no longer be economically viable.

The Federal Reserve needs to worry less about the culture and more about the future viability of its large capital market banks.