WHY ISN’T WALL STREET IN JAIL?

The title of this blog is a statement that has been debated in many leading American publications since the financial panic and market crash of 2008/2009. It’s also the title of a well written article by Matt Taibbi in March 3, 2011 issue of Rolling Stone  http://www.rollingstone.com/politics/news/why-isnt-wall-street-in-jail-20110216?print=true . The subtitle of Taibbi’s article says it all: “Financial crooks brought down the world’s economy — but the feds are doing more to protect them than to prosecute them.”

Taibbi’s writing is representative of the way many feel and raises the unanswered question of how is it possible that events which caused so much pain and destruction for so many people have gone unpunished by the criminal justice system?

Here is a little more from Taibbi’s article:

Nobody goes to jail. This is the mantra of the financial-crisis era, one that saw virtually every major bank and financial company on Wall Street embroiled in obscene criminal scandals that impoverished millions and collectively destroyed hundreds of billions, in fact, trillions of dollars of the world’s wealth —and nobody went to jail. Nobody, that is, except Bernie Madoff, a flamboyant and pathological celebrity con artist, whose victims happened to be other rich and famous people.

The rest of them, all of them, got off. Not a single executive who ran the companies that cooked up and cashed in on the phony financial boom — an industrywide scam that involved the mass sale of mismarked, fraudulent mortgage-backed securities — has ever been convicted. Their names by now are familiar to even the most casual Middle American news consumer: companies like AIG, Goldman Sachs, Lehman Brothers, JP Morgan Chase, Bank of America and Morgan Stanley. Most of these firms were directly involved in elaborate fraud and theft. Lehman Brothers hid billions in loans from its investors. Bank of America lied about billions in bonuses. Goldman Sachs failed to tell clients how it put together the born-to-lose toxic mortgage deals it was selling. What’s more, many of these companies had corporate chieftains whose actions cost investors billions — from AIG derivatives chief Joe Cassano, who assured investors they would not lose even “one dollar” just months before his unit imploded, to the $263 million in compensation that former Lehman chief Dick “The Gorilla” Fuld conveniently failed to disclose. Yet not one of them has faced time behind bars.

Yes, what Taibbi says is easy to sympathize with, but it isn’t the whole story. The bigger issue is about fundamental rules of capitalism. And what is defined as criminal conduct. We may call what the banks did as criminal in the vernacular, but it isn’t defined as criminal in the law. In our system of creative and destructive capitalism, too much government regulation can and will choke off the risky behaviors that create ultimate value and that define what entrepreneurs do. And, like scientific invention, it’s very hard to define what the line between innovative creation and destructive recklessness is. While it’s hard to define that line in a commercial environment, it’s even more important that such a line be cleanly defined if we want to apply it to our legal system, where (hopefully) more clarity and certainty  should be required.

I’ve always believed that the financial models designed by Wall Street’s “rocket scientists” and used by investment banks, while better than intuition in many cases, could fail at points of inflection (in a mathematical sense). The definition of this is that such a point can’t be modeled by simple linear, quadratic or other mathematically defined algorithms. And panics, by definition are always points of inflection. (The ‘Big Bang” that originated the Universe, according to modern physics, can be modeled back to within a very short time of the event itself. But what happened at the moment of the Bang itself? We don’t have those mathematical tools – yet.

The economics and business literature published since the great recession of 2008/2009 has made great notice of the fact that unusual events over many years appear much more frequently than a statistically normal distribution would predict. This phenomenon is sometimes called a fat tail (again referring to a normal distribution), a perfect storm or a black swan. All of these refer to the unexpected event relative to what some mathematical model would predict (This has also been shown to be  true for ocean waves, which should be modeled by the mathematics of fluid dynamics.) So at least we are all warned that there is potential disaster waiting if we don’t understand the risk involved in this increased probability of very unusual, and potentially destructive events.

In the creation of collateralized debt obligations (CDO’s), Wall Street told us that taking junk (low rated, high risk mortgages) and slicing and dicing them into tiny pieces and then randomly distributing them would make this junk into delicious cheesecake. But that model assumed that there would be no causal relationship between defaults, where in the real world, it’s clear that there are events which could cause a real relationship between one mortgage going bad and others in the neighborhood also going bad. And it’s clear to the beginning student in economics that exogenous events like a worldwide financial panic could cause whole bunches of mortgages to correlate in their defaults.

But here’s the BUT. By 2008, Congress hadn’t passed laws defining those bankers’ risky behaviors as criminal. In our system of capitalism, there needs to be some responsibility for one’s own behavior – caveat emptor that would apply to the buyers of those (as it proved out to be) risky CDO’s! And that is why I pushed for my children to get MBA’s – to be able to be aware of these kinds of sophisticated scams (as it turned out) and avoid them. It’s not perfect, but our economic system is still the best we’ve figured out so far. Certainly it has proven a lot better than the central government planning systems that were discredited at the end of the 20th Century. And these ‘black swan’ busts are a price we pay for our superior economic performance, as we’ve not figured out how to tune them out of the system. So Taibbi’s writing certainly appeals to our emotions, but it doesn’t show an understanding of how our economic engine runs. There’s no substitute for truly understanding what you’re doing or buying.