The activation of the administration's long dormant task force on criminal misconduct in the financial collapse, with New York's progressive attorney general Eric Schneiderman as co-chair, could be the most fateful political and economic development of the election year. There are still immense pitfalls ahead, as Wall Street allies inside the administration and on Wall Street itself try to reduce Schneiderman's role to that of symbolic fig leaf.
But President Obama has done something potentially momentous for which he deserves our praise, even if he himself does not fully grasp the implications. The significance of the shift is still in play, of course, and will be made clearer as events unfold over the next several weeks.
Some skeptics in the progressive community have raised questions both about the upside for Schneiderman and his motives. Given the administration's feeble record on prosecutions to date, the critics are right to flag the likelihood that people like Attorney General Eric Holder and SEC enforcement chief Robert Khazumi will try to sandbag Schneiderman. But my reporting suggests that they underestimate both the man and the dynamics that have been set loose.
The surprising move raises several questions.
First Big Question: Why did Obama, after letting the Treasury, Justice Department, and SEC sit on potential criminal prosecutions for three years, do this now? There was, after all, an inter-agency Financial Fraud Enforcement Group appointed in November 2009, and it contented itself with going after small and medium-sized fraudsters and settling mostly for slap-on-the-wrist civil fines, rather than getting to the bottom of the systemic crimes and bringing major cases.
The answer is in a harmonic convergence of three forces.
First, as illustrated by the larger themes of his recent State of the Union Address, Obama belatedly recognized an urgent political need for a more populist posture. What better bogeyman than Wall Street? Polls show that the single most damning factor that leaves voters skeptical about Obama's economic credibility is his coziness with the big banks. Pecking Paul Volcker on the cheek once a year just doesn't do it. Obama needed Schneiderman -- and not just as a symbol.
Second, the administration has fervently pushed, via HUD and the Treasury Department, for a soft settlement of the mortgage industry's failure to legally document the conversion of mortgages into securities and the systemic fraud in mortgage servicing that resulted. A series of court rulings have blocked foreclosures, because of such abuses as "robo-signing" of documents. Bankers, weaker state A.G., and the administration have been trying to close a deal where the banks are fined $20-25 billion, which goes for mortgage relief, in exchange for a general legal cleanup and protection from further liability. But this bad bargain was blocked by the steadfast opposition of the most important state attorneys general, notably the same Eric Schneiderman, plus California's Kamala Harris, Martha Coakley of Massachusetts and Beau Biden of Delaware. (Virtually all the trusts that hold securitized mortgages are created under the laws of New York or Delaware, so without Schneiderman and Biden, forget any deal.) In exchange for his cooperation with the administration on what is essentially a sideshow, Schneiderman held out for both a much tougher deal, and a major league prosecutorial task force.
Third, it has dawned on even relative conservative forces in Washington that the continuing mortgage crisis is a major economic drag on the recovery. With real estate values flat or continuing to decline, with homeowners out trillions of dollars of net worth, and tens of millions of mortgages still under water, the economy remains stuck in a deflationary cycle. The administration's small-bore relief programs, all of which are voluntary to the banks, have not done the job.
Surprisingly (and hopefully), the Federal Reserve -- of all institutions -- has been publicly pressing for more mortgage relief. This is crucial, since in the end game the Fed will be essential to a successful pivot from the leverage of criminal prosecutions to the remedy of much deeper mortgage relief -- if Schneiderman prevails. Pressure from the Fed to do more to fix the housing deflation will also serve as a political counterweight to those in the administration who hope Schneiderman will be just window dressing. More on that in a moment.
Next Big Question: Why did Schneiderman accept this appointment? Who is rolling whom? Some critics on the left have argued that Schneiderman has all the authority he needs under New York State law (via the Martin Act that was also used by Eliot Spitzer in extracting a global settlement of conflicts of interest by the banks a decade ago). This critique has been all over such blogs as nakedcapitalism.com and firedoglake.com. The critics conclude that since the Obama administration has not been serious about criminal prosecutions thus far, it logically follows that Schneiderman has been co-opted into a process that will tie his hands. But the real dynamics are far more complex.
There are certainly those in the administration who hope to sit on Schneiderman. You can see this in the dueling press releases to date. For instance, Eric Holder, in his Friday statement, included the unhelpful comment that "behavior that is unethical or reckless may not necessarily be criminal." This is of course true, but why on earth make that point in the context of announcing a new task force that is supposed to signal new toughness? It suggests that Holder, if left in charge, would pursue the same weak prosecutorial policies of the past three years.
But Schneiderman turns out to have a lot of leverage. Although the outlines of a narrow deal on the legal problems of mortgage servicers have been leaked, Schneiderman has not yet signed off on the deal. As noted, he has already gotten major concessions. The deal will only address the relatively narrow (but outrageous) abuse of robo-signing, and nothing in it will provide release from criminal prosecutions. Other details are still being negotiated. It is likely that Schneiderman will not give his final assent until he receives assurances on who will really be in charge of these broader investigations and with what level of resources.
The other main reason Schneiderman joined: The New York A.G. may have plenty of legal authority, but what he does not have is sufficient ground troops. In a scandal like this one, where the frauds and criminal misrepresentations are buried in millions of documents, it takes very major investigative resources, of the sort that the FBI, the IRS, the SEC, and the force of postal inspectors have, and the New York A.G. simply doesn't. Something like a thousand Federal investigators and prosecutors brought crooks to justice in the savings and loan scandals of the late 1980s. Though the numbers of people attached to the task so far are small -- Holder has announced a total of 55 attorneys and investigators to be assigned to the new working group -- we will soon find out whether enough people will be assigned to confirm to Schneiderman that this is a serious effort.
If not, we can expect him and the other progressive AGs to walk. And that is Schneiderman's other main source of leverage. In the jockeying for control, you might think that the odds overwhelmingly favor the insiders like Holder and Khazumi. But a high-profile criminal investigation that fizzled, with Schneiderman walking away, would be a massive political setback to the White House, more massive even than alienating some Wall Street campaign donors.
It would take a lot of guts for a Democratic attorney general to walk away from a presidentially created process in an election year. But if Schneiderman and the other progressive A.G.s conclude they are being rolled, they will walk and then do the best they can with the resources they have.
Schneiderman's goal, as far as I can tell, is to serve both justice and macroeconomic recovery. With fresh federal investigative resources, he can threaten bankers with legal Armageddon. Then, in addition to sending the worst malefactors to prison, he can entertain a settlement not in the tens of billions but in the hundreds of billions -- sufficient to provide very major write-downs of mortgage principal owed. That, in turn, changes the dynamics of the housing crisis as a drag on the recovery, which not incidentally serves the administration's economic and political needs.
As all this sinks in, you can just imagine the editorial in the Wall Street Journal. Extortion! The feds are threatening to send bankers to the slam in order to extort hundreds of billions for mortgage deadbeats. But extortion compared to what? The systematic, illegal fraud in mortgage securitization cost innocent homeowners trillions and the economy tens of trillions. The taxpayers went directly on the line to the banks for nearly a trillion in the TARP bailouts, and the Fed risked its own balance sheets to the tune of trillions more. Several hundred billion dollars of mortgage relief is pretty modest by comparison.
Though President Obama finally sounded more in tune with the anxieties of the average American in his State of the Union Address, he missed a huge opportunity by failing to challenge the "deadbeat" narrative long ago. For the most part, it was illegal behavior by the banks, and not the occasional deliberately improvident home buyer, that caused this collapse. Now, finally, we may get a reckoning.
This administration does not speak with one voice. While some senior officials may wishfully view Schneiderman as a useful idiot, the career prosecutors who have been champing at the bit and some on the White House political team view him as a heaven-sent counterweight to men like Geithner and Holder.
In less than a week, the momentum has already shifted. Critics who were skeptical a few days ago, Matt Taibbi for instance, are now applauding. Bloggers who were questioning Schneiderman's bona fides in taking the job are now making lists of legal angles for him to pursue. As public expectations build for a serious investigation and prosecution, it becomes progressively harder for Wall Street's cronies in Washington to shackle Schneiderman.
Big Question Number Three: Are plausible criminal prosecutions really possible? Short answer: yes. But it will take serious effort and resources.
One of the most irritating phenomena of the past three years has been the whining by protectors of banks to the effect that it's hard to get convictions in cases of financial fraud. But when the government decides to act in concert and throw the book at bank illegality, the dynamics change.
There was criminal fraud in every stage of the daisy chain of sub-prime mortgages and the creation and sale of securities backed by them -- in the misrepresentation of the quality of the loans, in the packaging of loans into securities, in the fakery of what documents were actually in the trusts, and in the marketing of mortgage-backed securities to investors. Mortgage servicers, in their attempts to collect payments, levy penalty charges, and to foreclose, also committed fraud when they misrepresented their documentation and property rights. At every step of the way, there were layers of lies. These lies violate innumerable statutes that carry criminal penalties.
Mail Fraud. While the statute of limitations has already run on some crimes, it is ten years in the case of mail fraud. The process of creating securities based on packages of high-risk mortgages that were misrepresented in trust documents, or the false notification of homeowners that they were delinquent, may have used Fedex some of the time, but it also relied on the U.S. Postal Service. The scale of manpower in the corps of postal inspectors and investigators, if deployed, gives Schneiderman resources simply not available to the New York A.G.
Securities Fraud. The entire structure of the securities laws in the United States is based on disclosure of risks that are material to the decisions of investors. The willful misrepresentation of actual risks was the essence of the strategy that enriched bankers and other middlemen, and crashed the economy. Mortgage-backed securities sold to the public are covered by the securities laws, as are sales of shares in banks. Misrepresentations were rampant. It was this prosecutorial leverage that led to the (paltry) civil settlements with Goldman Sachs, Countrywide Mortgage, and other malefactors -- that were and still are vulnerable to criminal prosecutions.
Bank Fraud. If the value of the underlying mortgages were misrepresented in official filings with bank regulators, that's bank fraud under the relevant banking statutes, which have long statutes of limitations that have not yet run. False accounting statements and false claims about internal controls are also a crime under the Sarbanes-Oxley Act. If statements are sworn, that's also perjury.
Tax Fraud. The entire process of securitization of bogus mortgages used tax-exempt conduits known as REMICs (The details are mind-numbing, but masochists are invited to Google the word REMIC). The sums were huge. The point is that if the packaging of mortgages was fraudulent and the IRS cracked down, everyone from bankers to individual trustees would be on the hook for hundreds of billions in back taxes and tax penalties. Faced with this kind of nightmare and the hit to their stock price while investigations proceeded, bankers would be inclined to settle.
Simply the fact of bringing serious criminal cases puts the fear of God into bankers and their lawyers.
Big Question Number Four: What signs should we be looking for to indicate success or failure?
For starters, will Schneiderman be operationally as well as nominally in charge? Will he get the investigative resources that he needs? Will Eric Holder stop being so defensive about his own record and give Schneiderman his full backing? Will President Obama stay focused on the infighting and support Schneiderman?
What back channel efforts will be used to blunt or block this initiative? You can just imagine the shudder that went though the ranks of the biggest banks, which have gotten off just about scot-free, when this task force was announced. They could now face massive fines, much reduced paydays, and even prison time. A progressive prosecutor like Schneiderman, wielding federal investigative resources, was their worst nightmare.
The banksters, of course, have close friends in high places. Jack Lew, President Obama's new chief of staff, was a protégé of Citibank's Robert Rubin. Lew served as Rubin's chief of staff at the Treasury Department in the mid-1990s, and then followed Rubin to Citi. Without the longtime patronage of Rubin, Obama's chief economic adviser Gene Sperling would be just another bright career policy-wonk. Sperling, in fairness, has tried to do the right thing within the very narrow confines of the Administration's mortgage relief policy to date. But this will be a whole new test of his judgment, principles, and ultimate loyalties.
Wall Street is also a principal funder of President Obama's re-election campaign. With the administration divided on whether this task force should be real or sham, the president will need to decisively conclude that economic recovery and his own credibility with the voters is more important than protecting his banker friends.
What about the timing? Subpoenas have already been issued, indictments are possible within months or even weeks, but the task force will have to go on overdrive to get a settlement this year that includes enough mortgage relief to make a near-term difference to housing markets and the macro-economic picture. Justice delayed is justice denied, and with the clock running on both the recovery and various statutes of limitations, that old saw was never truer.
A very encouraging sign would be the early exit of one Timothy Geithner. Secretary Geithner recently told a reporter that he would not be staying around for a second term. But if Geithner stays in office and is a decisive policy voice between now and November, Obama may not get that second term. Whether or not the president fully appreciates it, the new emphasis on prosecuting financial fraud is more than anything else a repudiation of Geithner and his policies. So why keep Geithner around to undermine the task force's work?
Last Big Question: What is the end game?
Bankers have escaped prosecution, and housing has stayed in a deep hole, in large part because of a disastrous decision that Geithner made in early 2009 -- the policy of extend and pretend. Rather than cleaning out and breaking up big banks, Geithner claimed that "market confidence" required the Treasury to collude in the fiction that all was well. It was just a temporary problem of liquidity.
Propping up the banks and their balance sheets, in turn, precluded serious relief of the mortgage crisis, since a write-down of mortgage debt would require banks to acknowledge real losses.
In some ways, a successful prosecutorial initiative returns us to the debates of early 2009: if cleaning up the mortgage mess requires banks to take a big hit to their balance sheets, how then do we proceed with a restructuring of the banks?
Since markets have already acknowledged reality by driving down the value of the banks' share prices, a settlement with much larger penalties, principal write downs, and even some prison sentences would actually be good for the banking industry because it would provide a fresh start with honest books. We could get beyond the "Japan" phase of this crisis, where the Fed has to keep pumping in trillions of dollars to disguise the real weakness of the economy and the banking industry.
It's helpful that the Fed recognizes the perilous effect of the mortgage collapse on the recovery, since Fed intervention will be central to restructuring and recapitalizing the banking industry after the task force brings bankers to justice.
Political junkies are fixated on the danse macabre of Newt Gingrich and Mitt Romney. But I could argue that the Mitt and Newt show is only the second most fateful election-year spectacle. More important is the question of whether Eric Schneiderman will be able to do his work.
Schneiderman has taken a stunning gamble. He may get the full cooperation that he needs, he may not. But one thing should already be clear. This is not a man who has been co-opted. He is nobody's window dressing.