Justice for Securities Fraud Raises Red Flags

For the past two decades high net worth individuals, with the help of Deutsche Bank, avoided U.S. government taxes. From 1996 through 2005 these individuals evaded approximately $6 billion in individual income taxes through tax shelters constructed by Deutsche Bank. Yesterday, Deutsche announced that it would settle the civil investigation for $553 million and admitted its wrongdoing in illicitly aiding clients in tax fraud. The $553 that Deutsche must pay represents the fees that the Bank collected from the transactions it facilitated plus a $149 million civil penalty. No Deutsche Bank executives were prosecuted; no employees are serving jail time.

This year Giuseppe Spera of Middletown, CT was also involved in criminal activities. He was accused of stealing $170,000 in cars from an auto dealership that he worked for. He was arrested by Middletown police, and as part of a settlement, he is expected to spend three years in prison.

The contrast between these two crimes raises concerns about the equity of our justice system. In looking at the Deutsche crimes it is unavoidable to not be alarmed by the absolute scale of the fraud – billions of dollars of fraudulent reporting leading to hundreds of million dollars of revenue for Deutsche. Guiseppe Spera, on the other hand, embezzled $170,000 of cars from his dealership employer. A crime, inexcusable, but also on a very different scale. Think about how society as a whole suffered as a result of these two crimes.

Our justice system’s punishment for the two crimes is also troubling because they create a startling dichotomy. Justice should serve two purposes: 1) Does the punishment fit the crime (i.e. “a proportional response” and 2) Does the punishment deter future criminal activities? In answering both of these questions, financial regulation and enforcement seems to be inadequate.

Solving the Securitization Problem: Some Suggestions for Regulators

Securitization is a very interesting topic and one which has aroused heated debate. Based on my last post, I want to clarify I few things about the role of securitization in the credit crisis. The blanket statement that securitization caused the credit crisis is overly simplistic and quite misleading.

In my last post I illustrated that in the years leading up to the credit crisis, securitization created moral hazards. However, the foundation of the moral hazards that arose were not so much created by securitization per se, but rather the lax regulation that allowed it to operate with few rules.

Securitization actually has many benefits for everyone (not just the banks which profited immensely). First, securitization lowers the cost of credit. What this means is that borrowing money is cheaper; small businesses, large businesses, and individuals alike benefit from cheaper credit in the form of lower interest rates on loans. Second, securitization expands credit – more opportunities are created for borrowing (see my prior post on the topic). Cheaper and more abundant credit fueled economic expansion and innovation, creating new jobs. 

The problematic moral hazards that occurred were not due to securitization. By this, I mean that securitization does not inherently have to cause a situation of moral hazard. This is a key element of the story. In fact, I can think of many ways that regulators could have allowed securitization to exist and eliminated moral hazards. For instance, let’s say a mortgage lender originates one thousand mortgages and then securitizes these into a mortgage pass-through security.  If it sells the entire mortgage pass-through security to investors it will have no concern for the quality of the mortgages that were originated. Future defaults by borrowers will not cause the bank to lose money, but rather the losses will be the burden of investors that bought the mortgage pass-through security. However, if regulators were to require the bank to hold onto a certain portion of the mortgage pass-through security, the bank’s interests would be aligned with the investors. Both the bank and the investors would then have an inherent interest in making sure borrowers do not default.  Tragically, no such regulation existed and even today, a full two years since the start of the crisis, the government has failed to implement any such meaningful regulation to correct this problem.