Wednesday, November 14, 2012

the bailout era

Most Americans know about that budget. What they don't know is that there is another budget of roughly equal heft, traditionally maintained in complete secrecy. After the financial crash of 2008, it grew to monstrous dimensions, as the government attempted to unfreeze the credit markets by handing out trillions to banks and hedge funds. And thanks to a whole galaxy of obscure, acronym-laden bailout programs, it eventually rivaled the "official" budget in size — a huge roaring river of cash flowing out of the Federal Reserve to destinations neither chosen by the president nor reviewed by Congress, but instead handed out by fiat by unelected Fed officials using a seemingly nonsensical and apparently unknowable methodology.

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Now, following an act of Congress that has forced the Fed to open its books from the bailout era, this unofficial budget is for the first time becoming at least partially a matter of public record. Staffers in the Senate and the House, whose queries about Fed spending have been rebuffed for nearly a century, are now poring over 21,000 transactions and discovering a host of outrages and lunacies in the "other" budget. It is as though someone sat down and made a list of every individual on earth who actually did not need emergency financial assistance from the United States government, and then handed them the keys to the public treasure. The Fed sent billions in bailout aid to banks in places like Mexico, Bahrain and Bavaria, billions more to a spate of Japanese car companies, more than $2 trillion in loanseach to Citigroup and Morgan Stanley, and billions more to a string of lesser millionaires and billionaires with Cayman Islands addresses. "Our jaws are literally dropping as we're reading this," says Warren Gunnels, an aide to Sen. Bernie Sanders of Vermont. "Every one of these transactions is outrageous."

But if you want to get a true sense of what the "shadow budget" is all about, all you have to do is look closely at the taxpayer money handed over to a single company that goes by a seemingly innocuous name: Waterfall TALF Opportunity. At first glance, Waterfall's haul doesn't seem all that huge — just nine loans totaling some $220 million, made through a Fed bailout program. That doesn't seem like a whole lot, considering that Goldman Sachs alone received roughly $800 billion in loans from the Fed. But upon closer inspection, Waterfall TALF Opportunity boasts a couple of interesting names among its chief investors: Christy Mack and Susan Karches.

Christy is the wife of John Mack, the chairman of Morgan Stanley. Susan is the widow of Peter Karches, a close friend of the Macks who served as president of Morgan Stanley's investment-banking division. Neither woman appears to have any serious history in business, apart from a few philanthropic experiences. Yet the Federal Reserve handed them both low-interest loans of nearly a quarter of a billion dollars through a complicated bailout program that virtually guaranteed them millions in risk-free income.

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For the past two decades, according to a whistle-blower at the SEC who recently came forward to Congress, the agency has been systematically destroying records of its preliminary investigations once they are closed. By whitewashing the files of some of the nation’s worst financial criminals, the SEC has kept an entire generation of federal investigators in the dark about past inquiries into insider trading, fraud and market manipulation against companies like Goldman Sachs, Deutsche Bank and AIG. With a few strokes of the keyboard, the evidence gathered during thousands of investigations – “18,000 … including Madoff,” as one high-ranking SEC official put it during a panicked meeting about the destruction – has apparently disappeared forever into the wormhole of history.

Under a deal the SEC worked out with the National Archives and Records Administration, all of the agency’s records – “including case files relating to preliminary investigations” – are supposed to be maintained for at least 25 years. But the SEC, using history-altering practices that for once actually deserve the overused and usually hysterical term “Orwellian,” devised an elaborate and possibly illegal system under which staffers were directed to dispose of the documents from any preliminary inquiry that did not receive approval from senior staff to become a full-blown, formal investigation. Amazingly, the wholesale destruction of the cases – known as MUIs, or “Matters Under Inquiry” – was not something done on the sly, in secret. The enforcement division of the SEC even spelled out the procedure in writing, on the commission’s internal website. “After you have closed a MUI that has not become an investigation,” the site advised staffers, “you should dispose of any documents obtained in connection with the MUI.”

Many of the destroyed files involved companies and individuals who would later play prominent roles in the economic meltdown of 2008. Two MUIs involving con artist Bernie Madoff vanished. So did a 2002 inquiry into financial fraud at Lehman Brothers, as well as a 2005 case of insider trading at the same soon-to-be-bankrupt bank. A 2009 preliminary investigation of insider trading by Goldman Sachs was deleted, along with records for at least three cases involving the infamous hedge fund SAC Capital.

The widespread destruction of records was brought to the attention of Congress in July, when an SEC attorney named Darcy Flynn decided to blow the whistle. According to Flynn, who was responsible for helping to manage the commission’s records, the SEC has been destroying records of preliminary investigations since at least 1993. After he alerted NARA to the problem, Flynn reports, senior staff at the SEC scrambled to hide the commission’s improprieties.

As a federally protected whistle-blower, Flynn is not permitted to speak to the press. But in evidence he presented to the SEC’s inspector general and three congressional committees earlier this summer, the 13-year veteran of the agency paints a startling picture of a federal police force that has effectively been conquered by the financial criminals it is charged with investigating. In at least one case, according to Flynn, investigators at the SEC found their desire to investigate an influential bank thwarted by senior officials in the enforcement division – whose director turned around and accepted a lucrative job from the very same bank they had been prevented from investigating. In another case, the agency farmed out its inquiry to a private law firm – one hired by the company under investigation. The outside firm, unsurprisingly, concluded that no further investigation of its client was necessary. To complete the bureaucratic laundering process, Flynn says, the SEC dropped the case and destroyed the files.

Much has been made in recent months of the government’s glaring failure to police Wall Street; to date, federal and state prosecutors have yet to put a single senior Wall Street executive behind bars for any of the many well-documented crimes related to the financial crisis. Indeed, Flynn’s accusations dovetail with a recent series of damaging critiques of the SEC made by reporters, watchdog groups and members of Congress, all of which seem to indicate that top federal regulators spend more time lunching, schmoozing and job-interviewing with Wall Street crooks than they do catching them. As one former SEC staffer describes it, the agency is now filled with so many Wall Street hotshots from oft-investigated banks that it has been “infected with the Goldman mindset from within.”

The destruction of records by the SEC, as outlined by Flynn, is something far more than an administrative accident or bureaucratic fuck-up. It’s a symptom of the agency’s terminal brain damage. Somewhere along the line, those at the SEC responsible for policing America’s banks fell and hit their head on a big pile of Wall Street’s money – a blow from which the agency has never recovered. “From what I’ve seen, it looks as if the SEC might have sanctioned some level of case-related document destruction,” says Sen. Chuck Grassley, the ranking Republican on the Senate Judiciary Committee, whose staff has interviewed Flynn. “It doesn’t make sense that an agency responsible for investigations would want to get rid of potential evidence. If these charges are true, the agency needs to explain why it destroyed documents, how many documents it destroyed over what time frame and to what extent its actions were consistent with the law.”

How did officials at the SEC wind up with a faithful veteran employee – a conservative, mid-level attorney described as a highly reluctant whistle-blower – spilling the agency’s most sordid secrets to Congress? In a way, they asked for it.

On May 18th of this year, SEC enforcement director Robert Khuzami sent out a mass e-mail to the agency’s staff with the subject line “Lawyers Behaving Badly.” In it, Khuzami asked his subordinates to report any experiences they might have had where “the behavior of counsel representing clients in… investigations has been questionable.”

Khuzami was asking staffers to recount any stories of outside counsel behaving unethically. But Flynn apparently thought his boss was looking for examples of lawyers “behaving badly” anywhere, includingwithin the SEC. And he had a story to share he’d kept a lid on for years. “Mr. Khuzami may have gotten something more than he expected,” Flynn’s lawyer, a former SEC whistle-blower named Gary Aguirre, later explained to Congress.

Flynn responded to Khuzami with a letter laying out one such example of misbehaving lawyers within the SEC. It involved a case from very early in Flynn’s career, back in 2000, when he was working with a group of investigators who thought they had a “slam-dunk” case against Deutsche Bank, the German financial giant. A few years earlier, Rolf Breuer, the bank’s CEO, had given an interview to Der Spiegel in which he denied that Deutsche was involved in übernahmegespräche – takeover talks – to acquire a rival American firm, Bankers Trust. But the statement was apparently untrue – and it sent the stock of Bankers Trust tumbling, potentially lowering the price for the merger. Flynn and his fellow SEC investigators, suspecting that investors of Bankers Trust had been defrauded, opened a MUI on the case.

A Matter Under Inquiry is just a preliminary sort of look-see – a way for the SEC to check out the multitude of tips it gets about suspicious trades, shady stock scams and false disclosures, and to determine which of the accusations merit a formal investigation. At the MUI stage, an SEC investigator can conduct interviews or ask a bank to send in information voluntarily. In the Deutsche case, Flynn and other SEC investigators collected sworn testimony and documents indicating that plenty of übernahmegespräche indeed had been going on when Breuer spoke to Der Spiegel. Based on the evidence, they sent an “Action Memorandum” to senior SEC staff, formally recommending that the agency press forward and transform the MUI into a full-blown fraud case against Deutsche. Bumping a MUI up to a formal investigation is critical, because it enables investigators to pull out the full law-enforcement ass-kicking measures – subpoenas, depositions, everything short of hot pokers and waterboarding.

Breuer responded to the threat as big banks like Deutsche often do: He hired a former SEC enforcement director to lobby the agency to back off. The ex-insider, Gary Lynch, launched a creative and inspired defense, producing a linguistic expert who argued that übernahmegespräche only means “advanced stage of discussions.” Nevertheless, the request to launch a formal investigation was approved by several levels of the SEC’s staff. All that was needed to proceed was a thumbs-up from the director of enforcement at the time, Richard Walker.

But then a curious thing happened. On July 10th, 2001, Flynn and the other investigators were informed that Walker was mysteriously recusing himself from the Deutsche case. Two weeks later, on July 23rd, the enforcement division sent a letter to Deutsche that read, “Inquiry in the above-captioned matter has been terminated.” The bank was in the clear; the SEC was not launching a fraud investigation. In contradiction to the agency’s usual practice, it provided no explanation for its decision to close the case.

On October 1st of that year, the mystery was solved: Dick Walker was named general counsel of Deutsche. Less than 10 weeks after the SEC had refused to investigate the bank, the agency’s director of enforcement was handed a cushy, high-priced job at Deutsche.

Deutsche’s influence in the case didn’t stop there. A few years later, in 2004, Walker hired none other than Robert Khuzami, a young federal prosecutor, to join him at Deutsche. The two would remain at the bank until February 2009, when Khuzami joined the SEC as Flynn’s new boss in the enforcement division. When Flynn sent his letter to Khuzami complaining about misbehavior by Walker, he was calling out Khuzami’s own mentor.

The circular nature of the case illustrates the revolving-door dynamic that has become pervasive at the SEC. A recent study by the Project on Government Oversight found that over the past five years, former SEC personnel filed 789 notices disclosing their intent to represent outside companies before the agency – sometimes within days of their having left the SEC. More than half of the disclosures came from the agency’s enforcement division, who went to bat for the financial industry four times more often than ex-staffers from other wings of the SEC.

Even a cursory glance at a list of the agency’s most recent enforcement directors makes it clear that the SEC’s top policemen almost always wind up jumping straight to jobs representing the banks they were supposed to regulate. Lynch, who represented Deutsche in the Flynn case, served as the agency’s enforcement chief from 1985 to 1989, before moving to the firm of Davis Polk, which boasts many top Wall Street clients. He was succeeded by William McLucas, who left the SEC in 1998 to work for WilmerHale, a Wall Street defense firm so notorious for snatching up top agency veterans that it is sometimes referred to as “SEC West.” McLucas was followed by Dick Walker, who defected to Deutsche in 2001, and he was in turn followed by Stephen Cutler, who now serves as general counsel for JP Morgan Chase. Next came Linda Chatman Thomsen, who stepped down to join Davis Polk, only to be succeeded in 2009 by Khuzami, Walker’s former protégé at Deutsche Bank.

This merry-go-round of current and former enforcement directors has repeatedly led to accusations of improprieties. In 2008, in a case cited by the SEC inspector general, Thomsen went out of her way to pass along valuable information to Cutler, the former enforcement director who had gone to work for JP Morgan. According to the inspector general, Thomsen signaled Cutler that the SEC was unlikely to take action that would hamper JP Morgan’s move to buy up Bear Stearns. In another case, the inspector general found, an assistant director of enforcement was instrumental in slowing down an investigation into the $7 billion Ponzi scheme allegedly run by Texas con artist R. Allen Stanford – and then left the SEC to work for Stanford, despite explicitly being denied permission to do so by the agency’s ethics office. “Every lawyer in Texas and beyond is going to get rich on this case, OK?” the official later explained. “I hated being on the sidelines.”

Small wonder, then, that SEC staffers often have trouble getting their bosses to approve full-blown investigations against even the most blatant financial criminals. For a fledgling MUI to become a formal investigation, it has to make the treacherous leap from the lower rungs of career-level staffers like Flynn all the way up to the revolving-door level at the top, where senior management is composed largely of high-priced appointees from the private sector who have strong social and professional ties to the very banks they are charged with regulating. And if senior management didn’t approve an investigation, the documents often wound up being destroyed – as Flynn would later discover.

After the Deutsche fiasco over Bankers Trust, Flynn continued to work at the SEC for four more years. He briefly left the agency to dabble in real estate, then returned in 2008 to serve as an attorney in the enforcement division. In January 2010, he accepted new responsibilities that included helping to manage the disposition of records for the division – and it was then he first became aware of the agency’s possibly unlawful destruction of MUI records.

Flynn discovered a directive on the enforcement division’s internal website ordering staff to destroy “any records obtained in connection” with closed MUIs. The directive appeared to violate federal law, which gives responsibility for maintaining and destroying all records to the National Archives and Records Administration. Over a decade earlier, in fact, the SEC had struck a deal with NARA stipulating that investigative records were to be maintained for 25 years – and that if any files were to be destroyed after that, the shredding was to be done by NARA, not the SEC.

But Flynn soon learned that the records for thousands of preliminary investigations no longer existed. In his letter to Congress, Flynn estimates that the practice of destroying MUIs had begun as early as 1993, and has resulted in at least 9,000 case files being destroyed. For all the thousands of tips that had come in to the SEC, and the thousands of interviews that had been conducted by the agency’s staff, all that remained were a few perfunctory lines for each case. The mountains of evidence gathered were no longer in existence.

To read through the list of dead and buried cases that Flynn submitted to Congress is like looking through an infrared camera at a haunted house of the financial crisis, with the ghosts of missed prosecutions flashing back and forth across the screen.

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