Wall Street feels the heat

The US government is taking action against people involved in the sub-prime mortgage crisis that has infected the entire financial system and which threatens a recession. By Stephen Foley

It's that time of the boom-and-bust cycle when the Feds crack out the handcuffs.

First in front of the cameras this time out, two heretofore obscure hedge fund managers from inside the defunct investment bank Bear Stearns. Matthew Tannin and his boss Ralph Cioffi, readied for their close-up, were taken in cuffs from Manhattan's FBI headquarters last week and charged in a Brooklyn courthouse with a fraud that cost their investors $1.6bn when the value of its holdings in sub-prime mortgages collapsed.

The two men sat at the end of a chain of connections across the mortgage and bond markets that has infected the entire financial system and threatens to plunge the United States into recession. At the other end, for millions of low-income homeowners unable to keep up payments on unsuitable mortgages, repossession looms.

It is an economic crisis and an election-year issue of such a proportion that the indictments of Messrs Cioffi and Tannin will not be enough to satisfy public pressure for wrongdoers to be brought to book. There will be more handcuffs. Bob Mintz, the head of securities litigation at the New Jersey law firm McCarter & English, said federal authorities will be painstakingly trying to build cases.

"In theory, the government is not supposed to respond to public pressure, but clearly when there have been staggering losses on Wall Street and investors have lost millions upon millions of dollars, these cases rise up to the top of the list in terms of priority and there is a push to respond with criminal charges," Mr Mintz said. "Of course, the need to show a rapid response is tempered with the need to build a successful case. The last thing the Department of Justice wants is a high-profile acquittal. It could be that this Bear Stearns case becomes a bellwether and will determine if we see a wave of future indictments or if the Department of Justice decides that the subprime crisis is too complex and too systemic to sustain a prosecution."

Certainly the government is keen to show it has put a cop on the beat. In an announcement timed to get on the same TV news reports as the Bear Stearns arrests, the deputy Attorney General, Mark Filip, said the FBI was leading a "sweep" of the mortgage industry and had charged more than 400 people already, including 60 in one day. Those named in the cases include housing developers, mortgage lenders and brokers, lawyers and estate agents, accused of aiding the submission of fraudulent mortgage applications. Meanwhile, the FBI is investigating about 19 much larger mortgage-related companies including, according to leaks, the collapsed New Century Financial and the biggest mortgage lender of them all, Countrywide Financial, led by Angelo Mozilo, who became a favourite whipping boy of politicians on Capitol Hill because he repeatedly sold stock in the months before the company's fortunes deteriorated.

On Wall Street, the Securities and Exchange Commission and the Department of Justice are investigating whether banks and other investors, including the insurance giant AIG, mislead investors by overstating the value of their holdings in sub-prime mortgages and other credit derivatives. Other squalls that might yield prosecutions include the gumming up of the auction rate securities market in February, when large brokers including UBS and Citigroup stopped supporting the market and hundreds of thousands of investors who believed the securities were the equivalent of cash found they could not sell them.

With so much to chew over, federal authorities have banded together under local DoJ attorneys, creating "task forces" pulling in representatives of the FBI, the SEC and even the US secret service, plus a slew of other local and federal agencies.

They need to follow a chain of evidence that might lead from a small town homeowner whose income was mis-stated on a mortgage application, through the broker who encouraged or made the mis-statement, via the lenders and up to the Wall Street banks that bought and packaged mortgages into new securities, and then finally to the banks and hedge funds which ultimately owned the mortgages.

There are accusations that banks and funds misrepresented the value of the mortgage derivatives they owned, and the revaluations to date have cost more than $400bn in writedowns and sunk numerous funds. Many in the finance industry, of course, say it is only in retrospect that it has become clear the securities were mispriced. In other words, we were stupid at worst, not fraudulent. That is certain to be the defence of Messrs Cioffi and Tannin, who say they are being made scapegoats for a market crisis that blindsided them in the same way it took others by surprise.

The legal threats to executives come not just from the federal government and from ambitious DoJ attorneys – many of whom use high-profile prosecutorial careers as a springboard for their political aspirations – but also from the states. Attorneys-general, the chief prosecutors in the states, are publicly elected and responsive to popular outrage. Eliot Spitzer, New York's now-disgraced former attorney-general, harried Wall Street during the dot.com bubble, prosecuting conflicts of interest and extracting multi-billion dollar legal settlements that got him elected governor of New York and even talked of as a future presidential candidate.

Prosecutors in Connecticut, New York, Illinois, Massachusetts and Ohio are among those who said they are looking into aspects of the finance and mortgage industries. Mr Spitzer's successor in New York, Andrew Cuomo, for example, is investigating whether Wall Street banks withheld damaging information about the mortgages they packaged into derivatives called collateralized debt obligations (CDOs) of the sort that the Bear Stearns hedge fund managers invested in.

At this stage, there is little to suggest their investigations will take them all the way to the chief executive's offices of the major Wall Street banks – but there is nervousness all round, and it could be years before all those ousted executives can feel comfortable spending their pay-offs.

"In the Enron case, despite tremendous public pressure to act, it took the government a number of years to bring a case," said Mr Mintz. "In this Bear Stearns case, the government has moved fairly quickly because, although the sub-prime crisis was fairly complex, the criminal charges here are simple, a garden-variety fraud alleging these managers were telling the investing public one thing while really seeing a far gloomier prospect for the success of their funds. The question is whether they went beyond permissible spin to outright fraud, and it remains to be seen whether the indictment will take on a different look once the full picture emerges."