The Justice Department’s recent action against Standard & Poors over that firm’s ratings of mortgage-backed securities in the run-up to the 2007 economic debacle is causing some controversy.
Sundry commentators — wondering if the action is payback for S&P’s downgrade of U.S. Treasury bond ratings in 2011 — ask why similar action has not been taken against the big investment banks and commercial banks, or why no one has been sent to jail for our current problems. After all, more than 800 savings-and-loan executives did at least a little prison time for breaking banking laws in the 1980s.
Many of these questions reflect legal and political issues rather than economic ones. But the outcome will have some effect on the economy, and economics has something to say about legal enforcement. So the action is a good topic to consider.
Start with some of the basics, and these are complex. First of all, S&P is not being charged with a crime. Even if Justice is entirely successful, no one will go to jail. It is instead a civil action seeking money damages.
Ironically, for those who contrast the outcome of the savings-and-loan scandal with today’s situation, the law under which Justice is bringing suit, the Financial Institutions Reform, Recovery and Enforcement Act, was written specifically to correct problems raised by the S&L scandal. Some of these were structural, such as abolishing the Federal Savings and Loan Insurance Corp. and Federal Home Loan Bank Board and setting up the Resolution Trust Corp. that liquidated hundreds of dud S&Ls.
However, the act also strengthened the civil sanctions and criminal penalties for defrauding or damaging depository institutions. This is what Standard & Poors is being charged with. By issuing knowingly fraudulent ratings of increasingly complex mortgage-backed securities, S&P supposedly defrauded financial institutions that bought them.
As noted above, the act does include the possibility of criminal penalties. So why is Justice bringing a civil suit now?
The answer is that civil suits have a lower standard of proof than criminal ones. For the Justice Department to win, the jury need only be convinced “by a preponderance of the evidence” rather than “beyond a reasonable doubt,” as needed for criminal convictions. The fact that Justice chose to go the civil route rather than the criminal one probably indicates that it is unsure whether the evidence is sufficient to meet the criminal standard of guilt.
Or, knowing that defendants always are willing to spend more on legal measures to avoid a criminal conviction than merely have a civil decision go against them, Justice may have made a simple marginal cost-marginal benefit calculation.
The added effective punishment that might be obtained through a criminal action simply was not large enough to justify the extra expenditure of money and staff time that would be necessary.
So why charge S&P, if Moody’s and Fitch, the other two rating agencies, are not being charged? I’m no legal expert, but I think this may yet happen.
Anecdotal evidence suggests these two agencies followed exactly the same practices as S&P. But perhaps their employees did not leave such a damning trail of internal emails. Moreover, wise prosecutors follow the same strategy as lions hunting wildebeests on the Serengeti Plain. Start with the easiest one to kill and then proceed to others. Moody’s and Fitch are not out of the woods.
But why pick on the ratings agencies and not on the investment banks putting “toxic waste” into securities? Why bring charges of fraud against the likes of Washington Mutual, Countrywide and other mortgage originators or their new parent companies? This will be a big question over the long term.
In an extensive April 14, 2011, story, New York Times reporters Gretchen Morgenson and Louise Story detail numerous situations that may have involved prosecutable criminal actions that have been ignored.
This piece also notes a decision by Michael Mukasey, attorney general in the last 14 months of the George W. Bush administration, to limit Justice Department and FBI efforts to investigate criminal actions in the debacle. But while Justice Department under Eric Holder did initiate a few unsuccessful criminal actions and several successful civil ones against financial institutions, criminal prosecutions have not been a high priority for the Obama administration either.
So what economic benefit is there from a civil or criminal action like this?
Gary Becker, a University of Chicago professor who won a Nobel for his examination of the micro-economics of individual behavior, including decisions about having children, argues that criminals make rational cost-benefit decisions when choosing to commit crimes. If the extra satisfaction gained from committing the crime outweighs the dissatisfaction of any possible punishment for it, multiplied by the statistical probability of being caught and convicted, then go ahead and commit the crime.
If you want to deter crime, the argument goes, you need to either increase the possible punishment and/or the statistical likelihood of arrest and conviction.
There is much evidence that such cold calculations do not play nearly that large a role in most decisions by individuals to murder or to steal. But if there is any sector in which cold financial calculations take place, it is on Wall Street.
Increase the expected cost and likelihood of being caught and you decrease the likelihood of transgressions.
Some commentators note that the government played a role in causing the debacle. This is all true, just as it played a role in causing the S&L crisis. But just because there is no practical way to punish all of the responsible does not mean we should reject punishing some who have clearly broken the law.