The very recent history of Wall Street abuses

The very recent history of Wall Street abuses

In a sense, the complaint brought against JPMorgan Chase for bad behaviour in the mortgage market is history. It concerns Bear Stearns, the ill-fated investment bank acquired by JPMorgan in spring 2008 as the financial crisis broke out.

But the suit from Eric Schneiderman, the New York attorney-general, which is part of a broader regulatory initiative to crack down belatedly on mortgage securitisation abuses, is still a fascinating portrayal of how bad things got.

Essentially, investment banks did not care too much about the quality of the mortgage loans they were packaging into securities because they took fees upfront, while not suffering the ensuing credit losses.

As the suit puts it:

“Faced with the promise of immediate, short-term profits and no long-term risks, originators began to increase their volume of home loans without regard to prospective borrowers’ creditworthiness – including their ability to repay the loan.”

In this case, Bear Stearns – known as being among the most footloose and fancy-free of Wall Street institutions – is alleged to have packaged an enormous number of loans that borrowers had already ceased to repay. The losses suffered by investors amounted to $22.5bn – some 26 per cent of the principal.

There are a few lessons here.

One is that financial incentives determine much of what happens on Wall Street and in the City of London. If there is a short-term incentive to mis-sell something, it will happen – a fact that banks are trying to counteract by reforming bonus structures.

A second is that many banks did not feel much compunction about selling securities of this nature because they regarded investors such as Dexia, the European bank, as fair game. They were wholesale investors and the entire market was run on the basis of “buyer beware.”

Last, this disaster was a long time in the making. It started with the invention of the credit derivatives market in the mid-1990s with the reasonable objective of spreading risk away from bank balance sheets. It gradually morphed into a game of banks trying to obtain mortgages purely so they could be securitised at a profit.

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