Why Isn't the SEC Cracking Down Harder on Banks?

Dec 15, 2011Bruce Judson

money-justice-scalesBetween underfunding and the perpetual revolving door, it's clear that the SEC isn't helping the system function well.

money-justice-scalesBetween underfunding and the perpetual revolving door, it's clear that the SEC isn't helping the system function well.

In an earlier column, I wrote about the intersection of equal justice under the law and capitalism. The idea of fair bargain is central to a capitalist economy: Both the buyer and seller in any transaction must believe they fully understand the nature of the good being bought or sold (i.e. no fraud is involved). Since no one is omniscient, the remedy for bargains that the buyer or seller believes are unfair is legal enforcement. At the same time, both parties to the transaction must believe wrongdoing by either party will be enforced with equal vigor.

At the time, I referenced the SEC case against Citigroup and criticized the relatively small fine the SEC had imposed, suggesting it was evidence of a broader problem related to meaningful enforcement of the laws by the agency. As background, SEC settlements must be ratified by the court, and a central aspect of these SEC settlements is that defendants "neither admit nor deny the allegations." Rarely does the court fail to endorse an agreement proposed by the SEC, since it's the prosecuting party. Since then, the Citigroup case has received considerable attention, as U.S. District Judge Jed S. Rakoff rejected the proposed settlement, calling it "neither reasonable, nor fair, nor adequate, nor in the public interest."  He both criticized the typical SEC "neither admit nor deny" form of settlement and called the SEC negotiated fine "pocket change" for Citigroup. Today, The Wall Street Journal indicated that the SEC enforcement division is expected to recommend to SEC commissioners that the Judge's decision be appealed.

These recent events beg a deeper look at the system of SEC enforcement. Why has the SEC apparently pursued such minimal settlements? The answers are surprising in that they reflect a wide discrepancy of views.

I found three very different explanations. But they all suggest that we have a broken system that must be fixed so that capitalism can operate properly.

First, the SEC enforcement division is underfunded and therefore lacks the resources to pursue a large number of complex trials. Critics say this reflects a deliberate effort by Congress, influenced by large financial institutions, to prevent punishment for malfeasance.  If true, this suggests yet another example of how our largest financial institutions  are preventing actual capitalism from functioning, often in ways that are not obvious.

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Second, without the no admission of guilt clause, defendants would open themselves up to a stream of well-funded plaintiff actions based on admitted guilt and even risk bankruptcy. In essence, the proponents of this explanation suggest SEC fines are considered a cost of doing business, but if injured customers have an adequate chance of redress then the punishment will more closely relate to the injuries caused by the illegal actions involved and this worries the banks. Judge Rakoff's opinion sharply criticized the settlement in this regard, indicating it "depriv[ed] the pubic of ever knowing the truth in a matter of obvious public importance."

Third, it can be explained by the revolving door, where former SEC enforcement officials are "going to work for the very same firms they used to police." Top SEC enforcement officials represent some the clearest examples of people who move out of government to high paying jobs in the private sector. This has a chilling effect on the efficacy of SEC efforts related to the largest, most powerful institutions. If true, we need to find a fair system that will both attract talent to the SEC but prevent this phenomenon.

There are several implications to these different explanations for what is clearly a broken system. Without the deterrent effect of the credible threat of law enforcement, the financial services industry will continue its malfeasance. The additional deterrent effect of successful private lawsuits based on a pre-existing admission of guilt is lost when the SEC uses the no admission of guilt standard. This raises a central question: Is the SEC's role in our society to punish and deter malfeasance, or is it to help victims more easily recover losses resulting from misconduct? If it is the latter, then finding the actual truth of guilt or innocence would serve a strong societal interest.

Additionally, the knowledge that the SEC always settles suits will inevitably start to enter into the thinking of potential bad actors. Here again the deterrent effect is minimized. It becomes easy to imagine bad actors discussing an issue and saying, "What's the worst that could happen? We will settle with the SEC for far less than we will make on this deal and the details will never become public." Meanwhile, malfeasance by the financial sector has caused millions of people to suffer.

There are solutions to these problems. The Obama administration must insist on far more extensive funding for SEC enforcement. Then we need to remember the famous words of Justice Brandeis, who said, "We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can't have both." Perhaps, as recently discussed by The New York Times, it's time to reconsider the maximum size and concentration of power in our financial institutions, which seem to consistently interfere with the fair operation of capitalism.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Occupy Our Homes: Shining a Light on Our Great Failure

Dec 2, 2011Bruce Judson

house-in-hands-150The housing crisis is America's most urgent economic problem, but until now, it's been the farthest from policymakers' minds.

house-in-hands-150The housing crisis is America's most urgent economic problem, but until now, it's been the farthest from policymakers' minds.

A recent article on Salon reports that the Occupy movement is planning to begin a nationwide action protesting the foreclosure crisis. Whatever your views of the movement itself, they are casting a bright light on the place where capitalism, our democracy, and our society have all failed: the housing crisis.

The financial crisis effectively started with the housing crisis, and it will not end until we find a way to resolve the housing crisis. Economists who have repeatedly forecast a healing economy have misjudged the need for a healthy housing market as a central component for any type of economic recovery. The administration's current plans for preventing foreclosures are woefully inadequate and housing prices are likely to decline as much as 20 percent this year, so our nation's cycle of economic misery will continue.

Since the mortgage meltdown begin in 2007, six million homes have been lost  to foreclosure. At present, another four million homes are at some stage of the foreclosure process. As the New York Times recently reported, one of the nation's leading housing analysts anticipates that a "staggering" total of more than 10 million of the nation's existing 55 million mortgages are "reasonably likely to default." Another recent article noted, "If the U.S. foreclosure crisis were a baseball game, we'd probably be in the bottom of the fourth inning." This national tragedy is a long way from over.

The housing and foreclosure crisis represents a conundrum with plenty of blame to go around: banks that violated lending standards in a search for easy profits; the creation of complex mortgage-backed securities whose risks were not fully understood; borrowers who took on far more debt than they could afford; the list goes on.

What the Occupy protesters recognize, either explicitly or implicitly, is that since the start of the housing crisis, government actions have by and large penalized suffering homeowners while rewarding banks that should have failed because of poor business decisions. The government has not adequately enforced the laws associated with ensuring that foreclosures are valid, and it appears to have no concerns when banks wrongfully take possession of homes (which, I believe, used to be called "criminal trespass" and  "breaking and entering"). On the flip side, all of the administration's plans associated with helping homeowners facing foreclosure have failed miserably.

All of this is bad economics, violates the rules of accountability and equal justice that are essential to a viable capitalist economy, and undermines our democracy. The Salon article reports that the Occupy protesters plan to "disrupt" foreclosure auctions. These actions are strikingly familiar to the "penny auctions" that took place during the Depression era. As detailed in my 2009 book, It Could Happen Here, which focused on the danger of growing income inequality to our nation:

Civil disobedience can emerge, even among the most conservative and normally upright citizens. During the Great Depression, foreclosed farms were auctioned on local courthouse steps. As the situation worsened, farmers took matters into their own hands. In what became known as "penny auctions," neighbors of bankrupt farmers would gather for an auction, physically prevent people from bidding on foreclosed farms, and then bid a token amount for the farms with the goal of returning the homesteads to their original foreclosed owners.

What is striking is the lack of creativity or sense of urgency that has been applied to the housing crisis. Here is a guiding principle for action: Homeowners must remain homeowners. Yes, this may not be an idea that is universally supported. And yes, it may be unfair to those who acted more responsibly. But the bailouts of the banks were also grossly unfair and I suspect hundreds of other significant, unfair government actions biased toward financial institutions and not consumers have taken place since the start of the crisis.

As a nation, we no longer have the luxury of concerning ourselves with fairness. Our economy is on life support, unemployment is far above the 6 to 7 percent level which then-candidate Obama called an "immediate economic emergency" when running for office in October 2008, and further declines in housing prices will send the economy into a greater tailspin.

We have adopted a dangerous complacency around the housing crisis that must be abandoned. If our economy and social fabric are to heal, a sense of urgency is desperately needed.

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One rarely remarked upon but dramatic aspect of the New Deal were the many innovations associated with ensuring continued homeownership. This was a central focus of FDR's effort to heal the nation. In 1933, Congress created the Homeowners Loan Corporation (HOLC), which bought up one in every five mortgages in the U.S. and reissued longer-term, lower monthly payment mortgages. In 1934, Congress created the Federal Housing Authority to insure long-term mortgages in a manner similar to the way the FDIC insures deposits, which ultimately made private lenders comfortable with 30-year mortgages. Most of us don't realize that the 30-year mortgage was effectively invented in the era of the New Deal and that previously mortgages ran for periods as short as five years.

A recent study estimated that 29 percent of all homeowners with mortgages are underwater, and it's likely that a sizable portion of this total is more than 25 percent underwater, which is generally agreed upon as the point where even solvent homeowners simply abandon their properties (also known as jingle mail, since the former homeowners send the house keys to the mortgage lender). As housing prices continue to drop, and I strongly believe they will, these numbers will continue to accelerate.

I do not have a specific policy proposal for fixing the housing crisis, but I have no doubt that with sufficient determination and creativity, this mess can be solved and we can move forward. The solution is likely to involve some pain on both sides -- losses for financial institutions and homeowners perhaps trading a portion of their equity (under the auspices of some new type of government agency) for a substantially lower mortgage principle. Or any number of completely different solutions. But both sides made mistakes and so shared pain is not a bad thing.

But what is bad is doing nothing. We simply cannot allow the impact of additional foreclosures to further destroy our economy or allow our social fabric to disintegrate as more and more people conclude that they were cheated out of their homes.

In the era of the New Deal, increasing farm foreclosures also led to riots and widespread violence in the Midwest, something we disregard today at our peril. In It Could Happen Here, I wrote:

These generally conservative farmers viewed their rebellion within the context of American principles.  Arthur Schlesinger, Jr., who published the three volume study The Age Of Roosevelt, wrote, "Theirs, as they saw it was the way not of rebellion but of patriotism." ...I have no doubt that these [rioting] farmers would have explained their actions as a combination of anger and righteousness that would be echoed in our modern era: A corrupt system of home loans, combined with an economic system that was run for the benefit of a privileged few, unfairly destroyed their lives.

The housing crisis emerged and has been exacerbated by a violation of the fundamental principles that make both capitalism and democracy work: accountability, bankruptcy for bad business decisions, enforcement of our laws, and equal justice.

I have written elsewhere that the Occupy movement will not simply disappear into the night. It is the flashpoint for the deep anger and sense of unfairness that pervades our society, for millions of people who feel their lives and dreams have been unfairly destroyed, while those who played a central role in causing their misery continue to profit. The transition of the Occupy movement to a focus on foreclosures was inevitable; this is the epicenter of our national tragedy.

The movement's focus on foreclosures will shine a necessary, even brighter light on our failure to address this central aspect of the financial crisis. These actions are an important and necessary wake-up call to our society about what is happening throughout the nation on a daily basis.

We can, of course, dismiss this latest act of protests. But if we do nothing, I wonder how far we stand from the violence of the New Deal era. At the time, FDR said, "The West is seething with unrest." Where will tempers flare next?

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Why Atlas Shrugged

Nov 18, 2011Bruce Judson

ayn-randAyn Rand's Objectivism glorified wealth-creators over moochers, but Wall Street traders might be surprised to learn which category they're in.

ayn-randAyn Rand's Objectivism glorified wealth-creators over moochers, but Wall Street traders might be surprised to learn which category they're in.

As the dysfunctional nature of our economy becomes increasingly apparent, the media is appropriately focusing on whether the ideas of economic thinkers from earlier eras can help to solve today's problems. Recently, NPR devoted a segment to the thinking of Ayn Rand.

The NPR segment quoted from an extensive television interview with her conducted by Mike Wallace in 1959, now available on YouTube.  As the segment noted, Rand is a hero to many Washington  politicians who advocate free markets. In the Wallace interview, Rand said, "I am opposed to all forms of control. I am for an absolute, laissez-faire, free, unregulated economy."

The Washington establishment has, in fact, misinterpreted what Rand valued and what she would advocate today.

At this moment, what's relevant to our nation is not  the laissez-faire policies Ayn Rand advocated in the late 1950s as an outgrowth of the philosophical system she called "Objectivism," but what the philosophy itself considered important, how these principles should be applied to our modern economy, and whether we believe implementing these ideas would aid the economy.

The central statement Rand stressed repeatedly in her interview with Wallace is that entrepreneurs and businessmen are the producers who create the goods and services that make our economy run. They deserve their wealth, are her heroes, and no one including the government has the right to take their property. As NPR notes, "In Atlas Shrugged, which Rand considered her masterpiece, the wealthy corporate producers are the engines of the American economy." In this fictional tale, the economy starts to stagnate when these producers go into hiding, leaving behind what she calls "the moochers."

In effect, an important aspect of Rand's philosophy supports the central tenet of a functioning capitalist economy: Those who create the greatest societal wealth should be the most highly compensated.

This is a fundamental notion in any capitalist economy. It underlies one aspect of the American Dream and also explains the historic admiration of the American people for rich people. In general (and before the Occupy Wall Street movement), the prevailing ethos in America has been that rich people deserve their wealth because they have created societal value for all of us. Indeed, I suspect the vast majority of the American people do not begrudge the wealth earned by successful, risk-taking innovators like Michael Dell, Jeff Bezos, the late Steve Jobs, or Ross Perot.

This leads to the conclusion that Rand's philosophy is only anti-regulation because it is ultra-supportive of the capitalist ideal: The people who create the most societal wealth should receive the benefits of this contribution.

From this perspective, Rand's philosophy points out that real capitalism is no longer enforced in America; not because of welfare programs, taxes, the social safety net, or government regulations, but for a very different reason: The highest paid people in America today create no real wealth for the society.

The financial industry, comprised of traders, hedge funds who exploit arbitrage opportunities, and "quants" who develop mathematical models to take advantage of minute inefficiencies in trading markets (for stocks, derivative securities of all types, commodities, and more) are now earning seemingly inestimable sums. Hedge fund owners earn billions of dollars annually while traders who earn less than several million dollars a year are not, by Wall Street standards, real successes. Yet they are all gambling in "a heads I win, tails you lose" game. The outcome of all their efforts are high profits, but little, if any, new societal wealth.

Real societal wealth is anything that enhances the lives of those in our society, starting with basics such as food, shelter and medicine, but also including almost any property a person can own or anything a person can experience, such as entertainment or greater convenience. Real wealth can be eaten, used, shared. or experienced.

Profits cannot be eaten and they do not provide shelter. As a consequence, it's essential to recognize that the creation of profits is often confused with the creation of real societal wealth. They are different. Profits are an accounting proxy we use for indicating whether wealth is created. But like all proxies, this one sometimes falls short. With regard to the financial industry, this proxy has failed the nation spectacularly.

The current issue of Foreign Affairs describes how a Wall Street firm spent $300 million to construct a fiber-optic cable connecting the Chicago Mercantile Exchange and the New York Stock Exchange to shave "three milliseconds off high-speed, high-volume automated trades-a big competitive advantage." And huge sums are now being spent to use technology to earn these profits. High frequency (i.e. computer-driven) trading is now estimated to account for 75 percent of all buying and selling of U.S. equities. Does any of this add to our societal wealth?

Some economists openly wonder whether our financial services sector actually destroys, instead of creating, societal wealth. In December 2008, Paul Krugman wrote in The New York Times (emphasis added):

The financial services industry has claimed an ever-growing share of the nation's income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it's not just a matter of money: the vast riches achieved by those who managed other people's money have had a corrupting effect on our society as a whole....

We're talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America's G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing - and it probably was - we're talking about $400 billion a year in waste, fraud and abuse.

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By 2009, Krugman noted that this view was now widely shared.

Yes, many financial economists have concluded that high speed trading and hedge fund arbitrage add to the efficiency of these markets. But I wonder if they have quantified the value to our society of these benefits and compared them to the very real costs. As far as I know, they have not. It's my understanding that they have only looked at the isolated impact of these activities on markets -- not their overall impact on our society.

This system, with the highest rewards going to those who create nothing, is antithetical to a capitalist economy. We have turned the underlying premise behind our entire economic system on its head. Now, those who create little, if any, societal wealth receive the most wealth in return.

Moreover, the wealth now inappropriately channeled to Wall Street is harming our society in a myriad of ways: First, money inevitably leads to political power through donations, lobbying, access, and more. Inevitably, trading-related money is now further distorting our capitalist economy by influencing legislation for its own anti-capitalist benefits.

Second, in a society where success is often defined by income (for better or worse) the talent the nation desperately needs to create real wealth is instead sucked up by the financial system and dedicated to arbitrage and other zero-sum activities.

Third, the speculative investments of hedge funds and other trading entities can have a dangerous destabilizing impact on markets and the prices of essential commodities (such as food and energy), and create systematic risk for the economy as a whole. In February of this year, Bloomberg highlighted a federal government report that found that "[h]edge funds and insurers might threaten U.S. economic stability in a time of crisis."

Fourth, it's likely that billions of dollars of our nation's limited resources are spent each year on infrastructure with no real societal value, all of which could instead be spent for productive uses.

Fifth, pay scales throughout the society are thrown out of whack as other elites start to question whether they should be earning similar amounts.

Finally, the notion that all profits are good -- whether they create real societal wealth or not -- is consistently reinforced through the highly publicized example of Wall Street earnings and applied with the same harmful effects in other industries throughout the nation.

Ayn Rand would, I believe, argue that this absolute failure to enforce capitalist principles is exactly what she most feared: The emergence of a powerful group that produces nothing, yet manages to takes a large share of the societal wealth created by others. In her view, this inevitably leads a society to implode and self-destruct.

Yes, Rand did not believe in altruism or any type of social safety net, and I am not addressing this aspect of her "Objectivist" philosophy here. But it is worth noting that she opposed these programs for the same reason I am certain she would be horrified by the current channeling of wealth to financial firms: She believed that they were allocating the benefits of production away from the rightful beneficiaries. Whether we agree or not with these assertions, they are irrelevant to this discussion.

I do, however, feel comfortable asserting that if she returned today, Rand would consider eliminating the transfer of un-earned wealth to the financial sector to be a far greater and far more urgent priority than addressing her beliefs related to the social safety net.

Unless we address the destructive effects caused by making speculators and traders the highest earning class in our capitalist society, the economy will remain dysfunctional.  In effect, the nightmare that Rand's philosophy anticipated for our economy is increasingly real, but because of the financial industry, not the social safety net or taxes.

Here's a final thought: In Rand's Atlas Shrugged, the industrialists who create the real wealth of the society start to disappear as they go into hiding. The trains that make the society work, both literally and metaphorically, stop.

So I have developed what we can call the Ayn Rand test of value: If securities traders and quants at investment firms and hedge funds started to disappear in large numbers tomorrow, would the trains that comprise our economy and society run better or worse?

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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How to Prevent a Housing Recovery: Accept a 46-State Mortgage Fraud Settlement

Nov 8, 2011Bruce Judson

home-foreclosure-documentThe settlement will do nothing to help fix the bruised housing market and may in fact have damaging consequences.

home-foreclosure-documentThe settlement will do nothing to help fix the bruised housing market and may in fact have damaging consequences.

There are two fundamental values that are essential to any working capitalist economy: accountability and the rule of law. The reported outlines of the  proposed settlement of the robo-mortgage scandal (no official details have been released) by 46 state attorneys general working together shows how far we have diverged from the basic principles of egalitarian capitalism.

This proposed settlement has no place in a capitalist economy. First, a successful housing recovery is essential to the ultimate recovery of the economy. So the implications of any settlement that potentially hurts the housing market are extraordinarily significant for the health of the nation. Second, it is based on principles that are unrecognizable in a nation built on capitalism and hence accountability and the rule of law.

Bank officials have testified in investigations of the robo-mortgage scandal that they submitted up to 10,000 false affidavits per month. Such testimony is effectively an admission of criminal guilt. These people admitted that, on behalf of their firms, they broke numerous criminal laws, most likely including conspiracy, fraud, and misleading the court.

The banks have attempted to deflect their misdeeds by suggesting that these illegal acts did not harm anyone. The laws were related to process only. The answer to such claims is that they are irrelevant. The banks are acknowledging that they perpetrated victimless crimes on a massive scale. And, each year, I suspect thousands of American citizens go to jail for perpetrating victimless crimes on a far lesser scale.

Moreover, these illegal acts demonstrate disrespect for the mortgage process. This same disrespect for appropriate processes, although not proven to be similarly criminal, is a large part of how our current mortgage mess was created in the first place. The banks ignored many basic underwriting rules in a rush to profit from extending as many mortgages as possible.

At this moment, I suspect the individual state attorneys general have the power, through civil suits and penalties combined with criminal prosecutions, to destroy the banking institutions that are guilty of this illegal behavior. This is, perhaps, the ultimate bargaining leverage, and it should only be given up in return for a settlement that will clearly heal the housing market.

Here are the several reasons why the proposed 46-state settlement is such a disastrous policy:

1. There is no overriding public interest in a settlement of the type proposed at this time. No one believes this settlement will fix the housing market. The state attorneys general are giving up leverage (which exists only through the banks' malfeasance) in return for what are minimal penalties to these giant financial institutions. As I previously pointed out, large monetary settlements have increasingly become a simple "cost of doing business" for financial institutions that break the rules.

To date, the Obama administration has attempted a seemingly endless number of programs designed to prevent foreclosures and heal the housing market. Each has been introduced with great fanfare and as an innovation that will not suffer from the failures of the previous program. Each has then failed.

I fervently hope that the latest program proposed by the administration will succeed. Unfortunately, I do not believe it will. My analysis, which is shared by professional housing economists, is that housing prices are headed substantially downward, by 20 percent or more, which will kick off a further weakening of the economy and a self-reinforcing system of foreclosures. This past Sunday, Joe Nocera's column in The New York Times profiled the analysis of Laurie Goodman, which says we should anticipate that a "staggering" 10 million of the existing 55 million mortgages will ultimately default. The country could not be more ill served by a policy that weakens our ability to ultimately end this cycle of destruction.

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2. Since the start of the crisis, my research has indicated that only a radical restructuring of homeowner debt, combined with innovations in housing finance, will end the crisis. Prior to the bailout, Obama had the opportunity to bring banks to the table to negotiate this necessarily extraordinary change. The opportunity was missed. We bailed out the banks, but not homeowners.

Now a second opportunity exists. The state attorneys general have the ultimate leverage to demand a restructuring of the housing market without legislation. Right now we don't know what this should look like or what form it should take. But to give up this opportunity -- until the statute of limitations is exhausted -- would be inexcusable.

3. The banks (and even some government officials) assert that a settlement will spur a recovery of the housing market and the economy. This is absolute nonsense. In the words of MIT's Simon Johnson (emphasis added):

With roughly a quarter of all U.S. households with mortgages owing more on their loans than their homes are worth, it's no surprise that consumption, which accounts for 70 percent of gross domestic product, is restrained.

The consequent lack of demand discourages business investment, which means job creation remains weak. People are afraid of losing their homes and that fear keeps spending down and thus prevents them -- and their neighbors -- from getting jobs.

What can be done to break this vicious circle? One suggestion from some officials... -- and of course many banks -- is to accept a relatively small amount of money to settle the various robo-signing and other mortgage document cases that state attorneys general are pursuing. The claim is that this would put the banks back on their feet and spur lending. This is a complete illusion.

4. State attorneys general working in a coordinated action may sound positive. But in fact, it violates (at least in principle) the notion of federalism and state sovereignty that is a vital part of our constitutional government. The federal government is the place for coordinated national action.

Many of the programs that ultimately formed successful aspects of the New Deal were first developed by FDR as governor of New York. In effect, the states are laboratories for experiments, which can then be expanded in scope through the federal government. At a time when economic uncertainty is so high, we should not abandon the virtue of multiple experiments by individual states.

5. It is by no means clear that this settlement will have a meaningful impact on banks' behavior. This behavior has been so egregious that even The Wall Street Journal has been forced to acknowledge it. The idea of entitlement is anathema to a capitalist system. Yet the more we punish massive rule-breaking with the equivalent of a slap on the wrist, the more we create the impression -- among the general citizenry and the elite -- that we no longer have a fair capitalist society. As a consequence, the settlement has a strong chance of encouraging further misbehavior.

6. My study of the effects of extreme economic inequality, published as It Could Happen Here, demonstrated that as economic inequality grows, political polarization increases and legislatures become paralyzed. Sadly, we are seeing this today.

In contrast, the robo-mortgage scandal provides an opportunity for action by courageous individuals (state prosecutors and attorneys general) that does not depend on a consensus, which almost certainly prevent innovation. These individuals can make a difference in the lives of millions who suffer today -- even as our Congress fails to act. I hope they do not shrink from this awesome responsibility, one that they may not have sought but nonetheless possess.

The New York Times reports that "a handful of state attorneys general became so troubled by the direction this deal was taking that they dropped out of the talks. Officials from Delaware, New York, Massachusetts and Nevada feared that the settlement would preclude further investigations, and would wind up being a gift to the banks." These attorneys general are to be commended, and the other states should follow their example. Hopefully, their stance will not weaken over time.

There is no reason to violate the capitalist ethos, which is built on accountability and the rule of law, by agreeing to a multi-state settlement. This ethos and the accompanying rules of behavior are what made us a great nation. The far wiser policy is to develop an understanding of what actions will heal the housing market and work toward implementing a policy that realizes them.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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Unequal Justice: Banker Arrests, 0; Protester Arrests, 2,511

Oct 27, 2011Bruce Judson

money-justice-scalesEqual justice is a basic underpinning of a healthy capitalist system. Without prosecutions for the financial crisis, that principle is being eroded.

money-justice-scalesEqual justice is a basic underpinning of a healthy capitalist system. Without prosecutions for the financial crisis, that principle is being eroded.

Since the start of the financial crisis, Americans have wondered why, if laws were broken, none of the occupants of Wall Street or other financial centers have been arrested. Now arrests are starting to happen with growing frequency. To date, an estimated 2,511 people have been arrested on Wall Street and elsewhere for activities related to the crisis. Unfortunately, it's the protesters who account for these arrests. So the tally to date: 2,511 people arrested for disturbing the peace and related activities; no arrests for any of the financiers who broke the law and plunged millions into untold misery.

"Equal justice under the law" is a cornerstone of the American Republic. In statues, Lady Justice is blindfolded to symbolize that justice is blind to the differences between the powerful and the weak, the rich and the poor. Today I fear that Justice's blindfold is in tatters and equal justice under the law has become a myth in the American economic system. Capitalism is not an abstract ideal. It is a set of rules and principles that, over the past two centuries, has combined with democracy to create a great America. Yet without blind, impartial, and equal justice, capitalism simply does not work.

The life-blood of any capitalist economy is the idea that a fair bargain is binding. Indeed, this principal was enunciated in the early days of the Republic in the famous Dartmouth College Case, when the Supreme Court ruled on the sanctity of contracts. A natural corollary of this principle is the notion that it will be enforced by our justice system with equal vigor for all of the parties to the contract.

There are four broad principles associated with criminal law that apply to a capitalist system:

First, stupidity -- no matter how great or how extreme the consequences -- is not a crime. Poor, high-risk decisions that led to the financial crisis are not, in themselves, criminal. Indeed, no economy can thrive if bad decisions carry criminal penalties. Crimes are violations of specific laws.

Second, there are at least two purposes in prosecuting an individual for criminal misconduct: punishment for misbehavior and changing behavior within the larger society. When a crime is prosecuted, it has a deterrent effect. The prosecutor is sending a message to the general public and anyone else contemplating such crimes in the future that this behavior will not be tolerated.

Third, prosecutors have discretion in pursuing a specific individual for an alleged criminal act. I have spoken with a host of prosecutors with regard to the financial crisis, and the most common answer is "these are hard cases to make" and "the budget to prosecute a complex financial crime is extraordinary." As a result, civil settlements, where the banks pay large financial penalties, have come to rule the day. (However, as discussed below, in many instances egregious violations of the laws make these easy cases to make.)

Fourth, as should be obvious, no individual in our society has the right to decide whether a law is irrelevant. Laws are the rules that everyone is expected to follow. This applies to every citizen, no matter how high or how low they stand in our society.

Now let's return to the financial crisis. In simple terms, three types of behavior have been documented: (1) "bad actors" who knew they were probably acting immorally but were not breaking the law, (2) activities that were most likely criminal, but without a trial no one has admitted to criminal behavior, and (3) admissions as testimony in open court of massive violations of the law (the robo-mortgage scandal is one example) with no prosecutions.

The consequences of the second and third type of behavior are inevitably calamitous for a capitalist economy. Business activity relies on the belief that, after the buyer and seller (or borrower and lender) have done all of their due diligence, our society will ensure that those who perpetrate false contracts will be punished. Fraudulent bargains will not be allowed. The alternative is massive uncertainty and a dysfunctional economy. For example, if a business person can't rely on the law to protect his or her rights in a transaction, the individual is not going to enter into new contracts. The net result: less investment, less economic activity, and far less innovation.

The SEC recently announced a $285 million dollar civil settlement with Citigroup. The firm had sold securities to investors and then turned around and shorted these same securities. The bank not only believed the securities would decline in value, but it actually spent its own money to make money off the terrible product it had sold to customers. Suppose I am in the jewelry business and I pretend that I am selling you a diamond that I know is really glass. I strongly suspect I would be guilty of some type of criminal fraud and would probably go to jail. At a fundamental level, I fail to see the difference between the jeweler and Citibank. Both have swindled the customer.

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(Some readers may be thinking about the sophistication of the investors and the many agreements they probably signed disavowing representations by Citigroup. However, the fact of the settlement suggests that improper behavior absolutely occurred -- if not, Citigroup would have fought the settlement. In addition, there is a strong argument that agreements that insulate any economic player from blatant misrepresentations should be void as against public policy.)

In a larger sense, the many financial institutions that have entered into settlements of hundreds of millions of dollars with the government are aware of all of the issues discussed above. My analysis is they have settled for two reasons: they don't want to risk criminal prosecution and they don't want the full details of their behavior to be discussed publicly in open court. And as noted in my earlier article, these settlements have become simply a "cost of doing business" for our increasingly monopolized financial sector and are unlikely to impact its behavior. In discussing the recent Citigroup settlement, The New York Times noted that "The settlement will refund investors with interest and include a $95 million fine -- a relative pittance for a giant like Citigroup. On Monday, the company reported that in the third quarter alone it earned profits of $3.8 billion on revenue of $20.8 billion."

The message to people and entities, large and small, is that they cannot rely on a blind justice system to protect them from unscrupulous transactions. The idea of fair dealing -- which is at the heart of our economy -- is breaking down. This implicit message also erodes the underpinnings of a vibrant capitalist economy. The rich and powerful can violate the law and will receive a slap on the wrist. As a result, the rights of the less powerful entities, which were violated by these elites, will not be protected by our justice system.

Sadly, it gets worse.

It can be argued that it is not absolutely clear that the many civil settlements do in fact reflect violations of criminal law. With limited public records and no prosecution, financial institutions can assert that I lack all of the relevant facts in my discussion above and that the decision by the government to limit enforcement to civil action is proof that no laws were broken. I disagree, but it is arguable. In contrast, there are areas where there is no question the law was massively violated. Financiers have admitted it. The cases are open and shut. Yet no prosecutions have occurred.

Both cases reflect the ultimate destruction of a capitalist economy. They prove that some participants are above the law. The concept of fair dealing collapses.

Moreover, small businesses, which are repeatedly recognized as a key source of new jobs, are the hardest hit in an economy where a bargain is not a bargain and laws are not equally applied. These businesses have the fewest resources to ensure their rights are protected. A new calculus is added to all of their activities: Will they be treated in accordance with the rules that govern our society? If not, how can they possibly risk new activities where their rights and potential profits can evaporate because Justice no longer wears a blindfold?

The consequences of the prosecutorial failure to indict even the most egregious violators of laws associated with the financial crisis are high:

First, it encourages the belief among our financial elites that they are above the law. The dangerous sense of entitlement I referenced in my earlier article is reinforced. A vibrant capitalist economy depends on what an individual accomplishes, not who they are. Financiers can, perhaps rightly, assume that no matter how badly they corrupt our capitalist system they will be spared any meaningful penalties.

Second, I would suggest that if prosecutors sent one banker to jail, they would cause a change in behavior throughout our financial institutions. If prosecutors looked for the person who most obviously violated the law, has already admitted it (so this is an easy case), and sent this perpetrator to jail, the deterrent effect would be high. Instead, the absence of prosecutions effectively validates ongoing criminal misbehavior throughout the financial sector.

Third, as these cases are publicized the public loses faith in our judicial system. Vibrant capitalism depends on the belief that everyone is treated fairly -- and bargains will be fairly enforced.

Finally, capitalism is, in part, based on the Horatio Alger ideal. If I play by the rules, the benefits of my work and innovations will accrue to me. When people lose faith in this ideal, they stop taking the type of risks that create great innovations. Now potential innovators must wonder whether law-breaking financiers will ultimately co-opt the societal wealth they may create. As their confidence in the fairness of the system erodes, so does their willingness to risk creating the new companies, and attendant jobs, the nation so badly needs.

Now let's return to the protesters on Wall Street. Almost 3,000 people have been arrested for activities that caused minimal, if any, injury to our society. At the same time, no financiers have been arrested for blatant legal violations, probably including extensive fraud, which have led millions of people to suffer and have practically brought our great nation to its knees.

There is constant discussion in Washington of economic healing and economic recovery. These can only happen when we return to the primary principles that made us a great nation. One of these paramount principles is that our capitalist economy requires a new blindfold for Lady Justice.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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The Kids Camping on Wall Street Are The Capitalists, Not the People in the Buildings

Oct 21, 2011Bruce Judson

occupy-journalWhich group is still abiding by the important capitalist principles of accountability, competitiveness, and equal justice?

occupy-journalWhich group is still abiding by the important capitalist principles of accountability, competitiveness, and equal justice?

Today, some of the leading capitalists in the nation are located on Wall Street. Sadly, it is the protesters outside who are literally on the street who embody the ideal rewards and responsibilities of capitalism, not the financiers who occupy the buildings.

This is the first in a short series of articles that explores the nature of a well-functioning capitalist system and how this system is now applied to the occupants of the buildings on Wall Street and those who are, quite literally, on The Street.

Capitalism is not an abstract ideal. It is as real as any market or currency. And it is the organizing principle that has, for over two centuries, powered the strength and resilience of America.

As we think about capitalism, it's also useful to make an important distinction: It's not what you say, it's what you do. You may espouse capitalist ideals, but if you oppose responsibility, dishonor contracts, oppose competition, and embrace government subsidies, you are not a practicing capitalist.

For capitalism to work, there are several fundamental requirements: accountability, equal justice under the law, a clearly articulated purpose (and accompanying cost) for government subsidies of a specialized class of citizens, competition, and a relationship between the creation of profits and the creation of real wealth for the larger society.

Many of the protestors in New York City and around the country are jobless college graduates. The majority in all likelihood financed their education through federally subsidized student loans. A central characteristic of today's generation of student loans is that, unlike most debts, they cannot automatically be discharged in bankruptcy. As a consequence, they are one of the few expenses in our society for which an individual is likely to be accountable throughout his life. As a nation, we teach our most promising youth, from the age of 18 on, the importance of accountability. We use the federal government to subsidize an investment in human capital. In return, the beneficiaries enter into a lifetime of responsibility and accountability. It is a sacred contract. It is arguably one of the best, and potentially harshest, lessons of accountability associated with capitalism in our society today.

Now, let's contrast this high accountability with the behavior that occurred in our financial sector. When our largest financial firms created havoc in the U.S. economy through undisputed greed, mismanagement, and extreme risk, some important things happened. First, the government bailed the companies out without demanding any substantial change in behavior, and then the individuals responsible were not held accountable through civil or criminal law. As a result, the people who brought the nation close to the brink of economic collapse and caused untold pain and suffering -- which continues to this day -- returned after a brief hiatus to record levels of compensation. Individuals who earned tens of millions of dollars continue to earn these extraordinary sums. They have never been called to account for their deeds.

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Can this be right? What about the many civil settlements negotiated by the federal government and the SEC? I would argue that, in light of the extraordinary profits these firms and individuals generate, such settlements are now viewed as a "cost of doing business." They appear to have almost no impact on the behavior or attitude of the nation's financiers.

Now let's contrast the kids on the street with the employees of The Street. The kids are accountable for their debts. They know it, and they simply want jobs so they can fulfill their civic responsibilities. In contrast, the occupants of the building on Wall Street act as if the rules of accountability -- which are central to a viable system of capitalism -- apply to everyone except them. Instead, many of the Wall Street elite have developed a dangerous sense of entitlement.

I would argue that in a true, competitive capitalist society, the idea of entitlement is anathema to all participants. It suggests that rewards are disbursed because of who people are, as opposed to the tangible wealth they create for the nation.

It's worth noting that old timers on Wall Street may still remember that until 1970 the New York Stock exchange mandated that investment banks be organized as some of the most accountable businesses in existence. Prior to going public, in the late 20th century Wall Street firms were organized as old-fashioned partnerships. The central idea of these partnerships was that every partner was fully liable for all of the debts incurred by the firm. If the partnership could not meet its obligations, the partners were required to meet these obligations with their own funds until they were personally bankrupt as well. It was a self-policing system that provided high incentives for investment banks to manage the risks they undertook. When every partner is liable, each has the highest possible incentive to ensure that the firm is not exposed to potential default. If they fail in this responsibility, both the firm and the individual partners can be wiped out. This rule was meant to avoid precisely what happened in the financial crisis.

Now these same publicly held financial institutions have been bailed out by the government and the high-paid executives are apparently immune -- both with respect to their pay, their sources of employment, and their personal funds -- from any day of reckoning.

The philosopher John Rawls is widely recognized for his theories of justice. In one exercise, his "veil of ignorance," he suggests that if you are faced with a decision you should pretend you don't know what kind of participant in the process you will be, so that "everyone is impartially situated as equals." Since you are blind to your own interests, you are likely to develop the fairest answer. (I have found this to be the perfect exercise for sharing desserts. I cut the cake and then let each individual choose a piece. Since I don't know what piece I will end up with, my cutting is far more likely to divide the pieces equally.)

Now let's apply a variant of Rawls's ideas to the situation on Wall Street today. You are a visitor from a foreign country or an alien world with no knowledge of Wall Street or capitalism. Then the principles of capitalism are explained to you and you are asked to identify the capitalists in this confrontation: the people in the buildings or the people congregating on the street. Which would you choose?

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.

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