Making the financial miscreants pay (it's harder than you might think)

In a comment to my rambling attempt to explain the mess that is AIG, curmudgeon57 asked:

At what point can we hold the board and officers criminally liable for running a scam? (if you sell something you can't deliver, you either have to return the money or go to jail. It's that simple, right?)

My friend Roger Parloff took a valiant stab at answering this—for Wall Street in general, not just AIG—in a Fortune cover story in January. His answer was that, in most cases, we won't be able to hold the board and officers criminally liable.

[B]ad business models - even business models that in retrospect look like prescriptions for disaster - are not crimes as long as they are fully disclosed to investors. And the fact that lenders were hawking outlandishly risky mortgages to people who were terrible credit risks was, in fact, no secret in America: It was bipartisan national policy. The fact that exotic mortgages (like "pick a payment option" ARMs and "Alt-A" loans with no documentation of the buyer's assets or income) were then being packaged into complex derivative securities - some rated AAA by Moody's, S &P, and Fitch - was not just well known but also hailed as ingenious by some of the putatively best financial minds in the country.

If CEOs did not foresee the imminent train wreck that, looking back, seems so inevitable, neither did former Federal Reserve chairman and erstwhile "maestro" Alan Greenspan, who has recently, if self-servingly, termed our predicament a "once-in-a-century credit tsunami."

A little further on, Roger writes:

The job of the prosecutors is not to ferret out the root causes of what went wrong with the economy. That's a task for historians. The prosecutors are to look for unambiguous, intentional wrongdoing - and since a lay jury will be the official scorer here, the simpler the wrongdoing, the better. While it might be true, for instance, that investors were misled by the way companies handled mark-to-market accounting of derivatives, a prosecutor who makes that the centerpiece of his case will end up with a swearing contest between opposing accounting experts - a morass in front of a jury.

So my answer to curmudgeon57 is, I dunno. There will be prosecutions of those who ran what seem to be obvious scams, such as Bernie Madoff. There will be many attempts to nail other Wall Streeters for crimes only tangentially related to their role in causing the financial collapse, because prosecutors at least stand a chance of winning those cases. But holding most of the people who got us into this mess criminally liable for doing so just isn't going to happen. And maybe we don't want it to: The former Countrywide president who is now running a company (PennyMac) that buys up delinquent mortgages and renegotiates the terms is providing a valuable service and helping clear the way for better days for all of us. Do we really want him behind bars? At the same time, his smug conviction that he's not in any way to blame for the housing mess is awfully hard to take. These people need to pay, somehow. But how? I've been struggling with this for a while. Here are the options I can think of:

1. Claw back the cash. Millions of Americans made big financial mistakes over the past five years. Only a few got paid millions of dollars (or hundreds of millions) for making them. Ever since Congress passed the Superfund law in 1980, polluting corporations have had to pay to clean up the messes they make. There are no punitive charges assessed. Just the cost of the cleanup. Why not demand the same financial polluters? I've written about this before, and the answer is that it's hard. There will be attempts—by plaintiffs' attorneys and by corporate boards of directors—to confiscate big executive paychecks that preceded implosions. But I don't see a lot of them succeeding except in cases of outright fraud. Congress could change the law to make clawbacks easier, but doing that retroactively seems awfully problematic. So does determining exactly who has to give their money back. For example: Is Hank Greenberg at fault for building AIG into such a monstrosity? Or would everything be okay now if Eliot Spitzer hadn't hounded Greenberg out of office in 2005 and left the company in the hands of lesser men? (I, like John Gapper, lean toward the former explanation, but it's not really up to me.) Morally, a well-targeted clawback is exactly what the financial world needs right now (the cash would come in handy, too). Practically, though, it's just not gonna happen.

2. Embarrass them on Capitol Hill. The 20th century saw two great Congressional inquiries into financial misbehavior—the Pujo hearings of 1912-1913 and the Pecora hearings of 1933-1934. The essential characteristic that both shared, other than their names begin with "P," was that the questioning was done not by blowhard members of Congress but by very smart New York lawyers hired by Congress: Samuel Untermyer in 1912-1913 (Arsene Pujo of Louisiana was the chairman of the subcommittee that held the hearings, but he let Untermyer do the talking) and Ferdinand Pecora in 1933-1934. So far all we've gotten from this crisis are some disappointing hearings where elected officials—most of them with little knowledge and no prosecutorial skills—ask the questions.  But both the Pujo and Pecora hearings did come several years after the financial collapses they were meant to investigate (the Panic of 1907 in Pujo's case, in case you were wondering), meaning that we've still got lots of time.

3. Raise taxes on high earners. The financial crisis (and subsequent government bailouts) and the years of plenty on Wall Street that preceded it together constitute a pretty appalling case of socializing risk and privatizing reward. So why not socialize the reward a bit more, by raising taxes on the biggest earners, many of whom are Wall Streeters? That's already the direction the Obama administration is headed in, but there are limits to this approach. For one thing, it's a pretty blunt instrument: There are lots of high earners who aren't engaged in activities that pose major systemic risks (for some reason, LeBron James keeps springing to mind). For another, if you take the whole socializing reward thing too far you risk strangling the economy. Although ... we had a 90%+ top tax rate in the 1940s and 1950s, and the economy didn't act particularly strangled.

4. Let them fail. Another way to remedy the mismatch of socialized risk and privatized reward would of course be to privatize risk. Financial sector risk has a bad habit of not staying in the financial sector, though, which is why we've been doing all these bailouts. I do think we've reached a point where we need to move from bailouts to workouts. But even those will still probably end up costing taxpayers a lot. And in most cases the people most to blame for the mess are already gone from the banks/insurance firms/etc. in question.

5. Wait for the historians, or at the very least for Bethany McLean and Joe Nocera's book. (Or Roger Lowenstein's or Andrew Ross Sorkin's or Barry Ritholtz's or somebody else's—I've got a book of my own coming out soon so I'd better not tick these people off. And while I really don't think Dan Gross's new ebook makes any pretense of being the definitive account of the crisis, I feel strangely compelled to inform you that it's available now on Kindle and the Sony Digital Book) The best post-crisis chronicles usually tarnish their chosen villains for decades to come, meting out justice in a way that the judicial system cannot. Until of course the revisionist histories come along decades later and turn everything upside down.

6. Something else. Tarring and feathering? Humanely administered flogging? Maoist self-criticism? If you have better ideas, let's hear them.

Update: More on the topic, along the lines of what meellerbee outlines in the comments, here.