From Brooks Brothers Suits To Orange Jumpsuits

It looks like Congress is finally getting around to trying to send those scoundrels to jail. The Wall Street Journal is reporting that a Senate panel is subpoenaing financial institutions to determine whether their investment bankers knew the mortgage-backed securities (MBS) and other toxic assets that they were selling were going to blow up. Their outrage is unsurprising, as those securities were the catalyst for the financial crisis. I think their anger, however, is misdirected. This is just another Congressional witch hunt.

Here's some detail from the WSJ:

The congressional investigation appears to focus on whether internal communications, such as email, show bankers had private doubts about whether mortgage-related securities they were putting together were as financially sound as their public pronouncements suggested.

I have so many problems with what's going on here that I hardly know where to begin. Let's start with the notion that some believe it's part of an investment banker's duty to protect investors from securities that the banker thinks are bad. There's a good analogy here to show why this is ridiculous -- especially in the case of MBS.

Imagine you're a used car dealer. Somebody brings in a car. Do you check that car inside and out to make sure it isn't a lemon before selling it to someone else? Let's add another layer of complexity. What if the person buying that car is a mechanical engineer who designs engines for Nissan? Oh, and the car was already checked by a 3rd party engine expert who verified its soundness. Is it still your fault if that car turns out to be a lemon?

Bear in mind, lemon laws ought not to apply. This wasn't any unsuspecting consumer -- it was someone who should have known better. And the car salesman went out of his way to get an independent expert to check out the car.

This scenario is exactly analogous to what went on with MBS. The banker was like the car salesman. The person he was selling it to was a large institutional investor who understood the risks. Those securities were also rated by agencies that have expertise in understanding how they should perform. Is it really the banker's fault if that security goes bad?

Next, let's think about a different, but analogous, service that investment bankers perform that has nothing to do with mortgages: initial public offerings.

Imagine an investment banker preparing an initial public offering of stock. Let's say that banker has significant private doubts about whether the company will ultimately succeed. That's irrelevant for two reasons.

First of all, nobody knows exactly what is going to happen with an investment. Just because that banker is unconvinced that a stock is going to do well doesn't mean that it won't. Nobody is right all the time.

Indeed, the vast, vast majority of the nation, including the financial community, had no idea the mortgage market would get as bad as it is. If a handful of investment bankers disagreed with that huge majority, I can't see how that minority view warrants jail time. When I was a consultant during the mortgage boom in 2005, I commonly traveled to the major mortgage companies in California. I often told people at those companies that they had to be crazy to think that housing wasn't going to crash. Instead, they said I was the crazy one. All I could do was shake my head in disbelief.

Second, an investment banker is just a middle man. It doesn't matter what he thinks. It's the company offering the stock's job to convince investors that the stock will be worth something down the road. It's the investors' job to do due diligence and figure out if that company is telling the truth. The banker just helps bring the two parties together.

The same applies with MBS. In fact, I'd argue that with debt, investment bankers' opinions matter even less, due to the involvement of a rating agency. Now the process works as follows. A mortgage issuer sends the banker a pool of mortgages. He sends that information to the rating agency. It tells him what loss and prepayment levels it expects. He then creates the bonds based on rating agency requirements and sells them to investors. Those investors buy those bonds based on their view of the mortgage issuer, data provided on those mortgages and rating. Where in that process does the banker's opinion matter?

Even if bankers had private doubts, that isn't fraud. Misrepresenting facts would be fraud. I highly doubt facts were intentionally misrepresented -- they didn't have to be. In the case of subprime mortgages, those facts clearly showed that the borrowers were of low credit quality. Investors scooped the securities up anyway.

The reality is that a lot of people made a lot of mistakes at a lot of different times to help create the perfect storm that led to the financial crisis. To try to pin that blame on a few bankers who might have had doubts about the mortgage market's viability is absurd.