After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

New York State Attorney General Andrew Cuomo has taken a refreshing approach to Wall Street’s new round of misdeeds. Rather than casting himself and the media as heroes—and Wall Street’s titans as villains—in dramas of crime and punishment, he has quietly filed cases and won investor restitution when the facts justify it. Comparing Cuomo’s approach to that of his sensational predecessor, Eliot Spitzer, underscores how free markets and the justice system can effectively complement each other. While criminal prosecution has its place in the markets, wronged investors are often better served by financial recovery through civil action than by empty revenge; and markets are better served by careful fact-finding and disclosure than by heated rhetoric.

Last week, Cuomo won huge concessions from three investment banks—Citigroup, Merrill Lynch, and Switzerland-based UBS—as part of an investigation of one aspect of the ongoing credit contraction. Cuomo’s investigators had uncovered evidence that the banks had misrepresented the risks of a debt investment called “auction-rate securities,” assuring customers that they were as safe and easy to access as cash and classifying them as “cash-equivalent” on customer statements. But starting in late winter, customers found that they couldn’t access their funds for immediate needs like mortgage and tuition payments, something that they could have done easily with real cash.

According to Cuomo, even after the banks had figured out that the securities weren’t like cash, they continued to assure customers that they were. In the fall of 2007, for example, UBS, a huge marketer of auction-rate securities, had known that new buyers weren’t coming forward—which meant that the existing owners might not be able to sell their holdings quickly and receive their cash. For a while, UBS itself purchased the securities. But the firm, reeling from emerging problems with its investments in mortgage-backed securities, couldn’t do that forever. So UBS, Cuomo notes in the lawsuit he filed against it, “redoubled its sales efforts to clients” so that customers would unwittingly solve the problem by purchasing more such securities. “We have encouraged our . . . partners to mobilize the troops internally to . . . move more product through the system . . . this is our best and most effective way of hedging our exposure,” wrote one UBS executive late last year.

It’s thus reasonable to believe that UBS failed in its basic duty to put customers ahead of its own interests and to disclose clear new risks to customers. (Arguably, UBS couldn’t have disclosed that it was thinking of stopping its own purchases of the securities, since that would have constituted inside information, but it should have disclosed that the market had deteriorated severely.) Then, this past February, UBS stopped buying the securities, and the market stopped up—leaving 50,000 customers unable to access their “cash.”

Further, according to the lawsuit, at least seven UBS executives sold “substantial amounts of their personal auction-rate securities” for a total of about $21 million after learning that they might be harder to sell in the future. One executive moved to sell just minutes after reading an e-mail unavailable to the public that contained information about the securities. Such allegations suggest that clients would almost certainly have appreciated knowing about the new risks.

Merrill Lynch, too, continued to market auction-rate securities as cash equivalents even after it knew that they were no such thing, according to evidence uncovered by regulators in New York and Massachusetts. It also seems to have taken steps to ensure that investors weren’t made aware of problems—again putting its own interests ahead of its clients’. Massachusetts investigators have found that Frances Constable, a Merrill executive in charge of selling auction-rate securities, sent an e-mail last year demanding a retraction of what she viewed as a negative note published by the firm’s supposedly independent research desk, which is charged with looking out for clients’ interests, not the banks’. “Shut this guy down,” Constable also told a colleague, referring to a Merrill financial adviser who had asked skeptical questions about the securities on a conference call. “He is focusing attention away from [your] positive message.” Of course, investors don’t need “positive messages”; they need clear and reliable information. As for the third firm, Citigroup: it opted to settle with Cuomo before he filed a lawsuit.

Cuomo’s treatment of these cases illustrates some crucial ways in which his approach differs from Spitzer’s. First, his chief aim seems to be to use the civil justice system to help thousands of misled customers retrieve funds, rather than to use their cases as sensational fodder for media circuses. Last week, UBS agreed to settle Cuomo’s investigations by repurchasing $11 billion worth of the securities from customers; a day earlier, in Cuomo’s settlement with Citi, the bank agreed to repurchase $7 billion from customers. In addition, Citi will pay a $100 million fine and UBS will pay $75 million. The banks will also reimburse customers who already sold their securities at a loss and pay customers for damages suffered because they couldn’t access their money (such damages to be determined by independent arbitrators). “Our goal is simple: to get investors back their money, and that’s exactly what this deal does,” Cuomo said. (While Merrill said last week that it too would repurchase customers’ auction-rate securities, and a fourth firm, Morgan Stanley, made a similar announcement this week, New York hasn’t closed out their investigations yet.) If you were a customer, which would you prefer: watching the attorney general embark on a high-profile crusade, or getting your “cash” back?

Second, the AG didn’t publicly threaten banks with criminal charges to get them to settle, as Spitzer did with Merrill Lynch in a conflict-of-interest case six years ago. Employees at the banks could certainly still be vulnerable to individual charges. But investors know that criminal indictment for a firm can be a death sentence, as the feds’ case against Arthur Andersen showed during the Enron scandals. So if Cuomo had threatened corporate criminal indictment, the banks would have had no choice but to settle—a point that they could have made in the press, weakening the case against them in the public eye. By calmly, reasonably laying out a civil complaint against UBS rather than threatening indictment (and thus customer and investor exodus), Cuomo allowed the evidence to speak for itself.

And by employing this strategy, Cuomo allows the market gradually and rationally to do the work that an indictment, or the threat of one, would have done suddenly and in a panic. UBS, Merrill, and Citi likely will suffer because of their own apparent actions—now adequately disclosed through New York’s and Massachusetts’s complaints—not because of outside threats of prosecution. If clients agree, by virtue of the information that the state regulators uncovered, that their banks seemed to care about themselves more than their customers, they’ll take their money elsewhere. Such flight is especially painful for the banks now, when their other lines of business—like mortgage securitization—have dried up.

In one way, Cuomo’s settlements illustrate how Spitzer’s policing of Wall Street was a missed opportunity. Five to seven years ago, when Spitzer was most active, investors clearly had cause for complaint and for regulatory redress. Back then, after the tech bubble burst, investment banks and employees had also put their own interests ahead of their clients’. People like Citigroup research analyst Jack Grubman, who traded favorable analysis of companies in exchange for personal favors, and Merrill analyst Henry Blodget, who privately bad-mouthed securities as worthless while publicly touting them to clients, were black eyes for Wall Street. Some of the goals of the reforms that Spitzer designed—including efforts to enforce the separation of supposedly objective research departments from sales and trading desks at big investment banks—weren’t unreasonable. But partly because Spitzer’s threats forced banks and government agencies to accede to his regulatory reforms in a panic, some details weren’t well thought out, and the reforms failed to achieve their aims even as they gave people false confidence that everything had been fixed.

Of course, five years ago is not today. Back then, the banks weren’t as ready to settle. They hadn’t collectively lost hundreds of billions of their shareholders’ dollars; they weren’t dependent on the federal government to stay afloat; and they could argue that customers should have known the risks of buying high-flying tech stocks—which are very different animals from the “cash-equivalent” securities of the current settlements. Cuomo’s gentler tactics might not have been as effective then as they are now.

But even so, Spitzer was far too eager to wield his greatest powers—the power to bring criminal indictments and the power to demonize and bully individual executives in the press—and to make himself the story. Without Spitzer to serve as a handy common enemy, perhaps some financial institutions and their investors would have looked inward instead and acknowledged the risks of a brittle business model—as they’re now forced to do.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.