Why Bankers Who Bilk Investors Out Of Billions Should Be Brought To Justice

 |  Includes: C, GS, JPM
by: Chip Krakoff

Less than a week after a federal court in Manhattan sentenced hedge fund boss Raj Rajaratnam to a record 11 years in prison for insider trading, and ordered him to pay forfeiture and fines of more than $60 million, comes the news that Citigroup (NYSE:C) has agreed to pay $285 million to settle a to settle a civil complaint by the Securities and Exchange Commission that it had defrauded investors.

According to last Thursday’s New York Times,

the transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value.

This is the third such complaint brought by the SEC. In July 2010, Goldman Sachs (NYSE:GS) paid $550 million to make the SEC’s charges go away, and this past July JP Morgan Chase (NYSE:JPM) settled its case with a payment of $154 million. None of the three firms has admitted any wrongdoing, and neither the firms nor any of their employees have been charged with any crime.

The substance of the SEC’s charges against the three banks is that each one constructed and sold a portfolio of collateralized debt obligations (CDOs) consisting mainly of subprime mortgage-backed securities, without disclosing to investors that it planned to short those assets. In the Goldman deal, investor John Paulson played a substantial advisory role in putting together the portfolio and then banked over $4 billion from shorting it.

Citigroup, for its part, shorted about $500 million of a $1 billion subprime portfolio, making $160 million in profits and trading fees while the biggest investor – Ambac Financial, which had sold credit default swaps to Citi, thus assuming the credit risk on a big chunk of the portfolio – filed for bankruptcy last year, having lost half a billion dollars in the deal. The Wall Street Journal, reporting on the SEC complaint against Citi, quoted one experienced CDO trader describing the portfolio in an e-mail as a “collection of dogs” and “possibly the best short EVER.”

This is serious fraud by any reasonable standard. The victims may have been sophisticated institutional investors, who perhaps should have known better, but a crime is still a crime, no matter how undeserving of sympathy its victims may be.

It is much harder to identify the victims, if there are any, in the Rajaratnam case. The prosecution, asking for a 24-year sentence, characterized Rajaratnam’s actions as “brazen, pervasive, and egregious,” and in pre-sentencing memos several SEC officials maintained that insider trading threatens the integrity of financial markets and diminishes confidence in their fairness. This is unlikely. Mr. Rajaratnam’s gains from several years of documented insider trading amounted to about $72 million. Since he was trading in stocks of hugely capitalized companies like Goldman Sachs, whose average daily trading volume amounts to around $850 million, it is ludicrous to think his activities had any detectable impact on stock prices.

Far more troubling is the ease with which Mr. Rajaratnam was able to suborn criminal breaches of confidentiality and fiduciary responsibility by people such as Rajat Gupta, former Managing Director of the consulting firm McKinsey, who has just been charged with five counts of securities fraud and one count of conspiracy to commit securities fraud in connection with his former positions as a director of both Goldman Sachs and Procter & Gamble (NYSE:PG).

Mr. Gupta is alleged to have tipped Rajaratnam to Goldman and P & G earnings reports as well as Warren Buffett's planned investment of $5 billion in Goldman Sachs before these were publicly disclosed, thus enabling Rajaratnam to make over $14 million by buying or shorting their respective shares. Former McKinsey Director Anil Kumar has already pled guilty to federal conspiracy charges for feeding Rajaratnam with information on McKinsey clients in exchange for more than $2.5 million. This, more than the insider trading itself, threatens the framework of law and trust within which a market economy operates, so merits severe punishment to which Mr. Gupta and others in Mr. Rajaratnam’s circle of conspirators, if found guilty, should also be subjected.

Proportionality is a basic principle of our justice system, even if it is often honored only in the breach. If Raj Rajaratnam deserves to spend the next 10 years in federal custody, surely the bankers at Citi, Goldman, and JP Morgan, who deliberately bilked investors out of billions of dollars, deserve much longer sentences.

Disclosure: I am long JPM.