Bank Is Victim in Financial Crisis Case, Not Homeowners

Less than a week after the formation of a new federal-state working group that will focus on potential misconduct in the residential mortgage-backed securities market came a case against three traders at Credit Suisse who were charged with inflating the value of mortgage bonds in late 2007. But the case has little to do with the causes of the housing market collapse; at its core, it is really akin to embezzlement from a bank by its employees.

The Justice Department filed charges of conspiracy, false accounting and wire fraud against Kareem Serageldin, who was a managing director at Credit Suisse’s investment bank division in New York. Two subordinates pleaded guilty to conspiracy charges and are cooperating with the prosecution, having admitted to inflating the value of mortgage bonds held by Credit Suisse at Mr. Serageldin’s direction.

According to the indictment, the motive for tinkering with the valuations was to enhance Mr. Seageldin’s job performance and eligibility for a promotion and bonuses at Credit Suisse. At one point, he rejected a proposed markdown of $15 million to $20 million on an investment, telling a colleague, “That’s a lot of money, dude,” and when an internal inquiry raised questions about a particular valuation, he said that the entry had been recorded by mistake.

Mr. Serageldin received a cash bonus of approximately $1.7 million and a stock award worth about $5.3 million in February 2008, which was rescinded after Credit Suisse wrote off approximately $2.65 billion on its mortgage positions a little over a month later. The bank immediately reported the valuation issues to the government, and it took almost four years to bring the charges.

Various news reports noted that this was the first case involving Wall Street traders filed since the failed prosecution of two hedge fund managers at Bear Stearns who were charged with misleading their investors about the value of mortgage securities the fund held. They were acquitted in 2009 on all charges, a result that raised questions about whether prosecutors could successfully pursue fraud cases related to the financial crisis.

Much like in that case, the charges against Mr. Serageldin are rooted in the collapse of the housing market, but have little to do with the fundamental causes of the financial crisis or the wave of foreclosures that hit homeowners. Credit Suisse was not named as a defendant, and has been portrayed as the victim.
Corporations can be prosecuted criminally for the conduct of their employees when individuals act within the scope of their responsibilities and the conduct was intended in part to benefit the company. This is called the “respondeat superior” theory of liability, and so corporations can be charged for the violations committed by anyone, from a janitor to the chief executive, even if no individual is prosecuted or convicted.

When employees act for their personal benefit, however, the company would not be held responsible for the violations. In Standard Oil Co. v. United States, the United States Court of Appeals for the Fifth Circuit explained that “the taking in or paying out of money by a bank teller, while certainly one of his regular functions, would hardly cast the corporation for criminal liability if in such ‘handling’ the faithless employee was pocketing the funds as an embezzler or handing them over to a confederate under some ruse.”

Mr. Serageldin is accused of overvaluing securities so that he could reap the benefits of meeting his profit targets, a fraud committed on Credit Suisse to obtain a bonus he would not otherwise be entitled to receive. As the victim of his scheme, the bank could not be charged with a crime.

Whether Credit Suisse was actually misled regarding the valuation of its mortgage positions will be a crucial issue in Mr. Serageldin’s case. In December 2007, UBS announced a $10 billion markdown of its portfolio as a result of “continued deterioration in the US sub-prime mortgage securities market, partly driven by increased homeowner delinquencies but mainly fuelled by worsening market expectations of future developments,” so problems with valuations of the bank’s mortgage positions may have been apparent to its management.

The timing of when Wall Street firms recognized losses in their mortgage portfolios is an important issue in assessing the causes of the financial crisis. This case puts at least some of the blame on a small group of rogue employees who were trying to protect their bonuses and future prospects, making the bank a victim along with the markets.

The larger issue of the harm to homeowners from foreclosures triggered by the collapse in the housing market has not yet been addressed in any criminal prosecutions. One of the goals of the new working group is “to compensate victims and help provide relief for homeowners struggling from the collapse of the housing market,” but the prosecution of Mr. Serageldin does not touch on those parties because the only one harmed was Credit Suisse.

A New York Times article highlights how Fannie Mae received information about improprieties in the foreclosure process a few years before the financial crisis hit, yet the company’s management appears to have ignored the issue. The likelihood of a criminal prosecution of any senior managers over foreclosure problems is quite low, however, because inaction is rarely the basis for charges. The civil case against Fannie Mae’s former chief executive, Daniel H. Mudd, involves allegedly misleading disclosures to the company’s investors, not the homeowners whose mortgages the firm bought and later foreclosed.

The prosecution of Mr. Serageldin demonstrates how easy it was to manipulate the valuations of mortgage securities that depended largely on estimates as the market for mortgage bonds dried up by late 2007. But the case says little about how the packaging of mortgages contributed to the losses suffered by homeowners or how the role of Wall Street firms in selling securities tied to the housing market impacted investors.

U.S. v. Kareem Serageldin