As Wall St. burns, regulators seek culprits

Loan brokers likely to be among first targets

The perp walk that develops out of the mayhem on Wall Street could turn into a long, twisted journey.

The FBI is reportedly investigating whether fraud was committed at four institutions at the heart of the current financial crisis - lenders Freddie Mac and Fannie Mae, the investment firm Lehman Brothers, and insurance giant American International Group. The development, first reported by the Associated Press, followed testimony last week by FBI director Robert S. Mueller III before the Senate Judiciary Committee, during which he said the bureau had already initiated 24 corporate fraud investigations because of the economic meltdown.

Look for the Department of Justice, state attorneys general, and various regulators to launch probes, said Donald K. Stern, former US Attorney for Massachusetts who now practices at the Boston law firm Cooley Godward Kronish. The easiest targets will come under scrutiny first, like mortgage brokers who wrote fraudulent home loans to borrowers who couldn't afford them, providing kindling for the conflagration that the subprime market would become. After that, investigators could target larger cases, including some aimed at people who might destroy documents or obstruct justice.

Market observers say the list of rogues could include lenders who knowingly wrote bad mortgages, investment bankers who sliced up loans and resold them without disclosing risks, and executives who recklessly heaped questionable investments onto their books.

"There are going to be some criminal investigations that come out of this, just because of the size of the dollars involved," said Stern.

"The blame is on all the participants," said Ben Howe, cofounder and chief executive of America's Growth Capital, a Boston investment banking firm. "You can't just put it on the reckless investment bankers - who clearly were reckless in their use of excess leverage - but also the policy makers. Investment banks and hedge funds went into the banking business, effectively, with more excessive leverage than the banks, and there were no regulators overseeing them."

Senator Patrick Leahy, the Vermont Democrat who heads the Judiciary Committee, made it clear at last week's hearing that someone - besides taxpayers - should pay a price.

"If people were cooking the books, manipulating, doing things they were not supposed to do, then I want people held responsible," he said.

Meanwhile, the regulators who failed to detect the problems - and even looked the other way - are less likely to come under fire, according to Stern. "If there was criminal conduct, it is rarely successful for a defendant to say, 'Even if I did it, it was because the regulators weren't doing their job.' That doesn't usually work," he said.

If prosecutions do result from the various probes, it would not be the first time a national financial scandal led to criminal charges against executives.

Seven years ago, the accounting and corporate governance schemes of Enron Corp. eventually sent some of that company's top officials to prison.

The savings and loan scandal of the 1980s ended in jail time for Charles H. Keating Jr., chairman of the Lincoln Savings and Loan Association, as well as numerous other bankers. Five US senators implicated in the Keating affair, including Republican presidential nominee John McCain, escaped with verbal criticism from the Senate Ethics Committee.

The savings and loan debacle was made possible by lax rules and overzealous real estate lending. It forced the government to establish the Resolution Trust Corp. to untangle the mess. The cost to taxpayers was about $125 billion.

Today's financial crisis has led to other investigations in addition to the FBI's inquiries into AIG, Lehman, Fannie Mae, and Freddie Mac.

The Securities and Exchange Commission said it has more than 50 open inquiries into firms involved in subprime mortgage securities.

The FBI and the Justice Department are investigating Countrywide Financial Corp., the home lender that sold a large portion of its risky loans to Fannie Mae and Freddie Mac. Also, Massachusetts Attorney General Martha Coakley has several civil cases pending against mortgage lenders.

In addition, the SEC is investigating firms with large positions in so-called credit default swaps. In testimony before the Senate Banking Committee Tuesday, SEC chairman Christopher Cox called the $58 trillion credit default market "completely lacking in transparency and completely unregulated."

AIG, bailed out last week by the federal government for $85 billion, made bad bets on credit default swaps.

Critics in the financial industry and academia insist the abuses would not have happened if federal and state regulators were doing their jobs.

For instance, banking regulators at federal and state levels failed to monitor lenders that were offering mortgages without following basic industry guidelines on income levels and without requiring appropriate documentation on applications. Those practices led to a high number of risky loans.

Republicans say Democrats encouraged the unbridled growth of Freddie Mac and Fannie Mae and then failed to grasp the precarious positions of the mortgage giants in time to head off a federal takeover this month. Both political parties underestimated the scope of the subprime mortgage crisis, critics say.

Then there were the failings of the SEC at the federal level and self-regulatory bodies like the Financial Industry Regulatory Authority, which supervises brokers. Those entities were supposed to oversee investment banks and brokers, partly to prevent the recent string of catastrophic financial failures that seemed to catch everyone by surprise.

While no one is pointing to any single regulator, the SEC has the broadest responsibilities, including monitoring the financial health and operations of investment firms.

John Heine, an SEC spokesman, said that since 2004 the agency has had the power to examine the books of investment-bank holding companies. But the staff charged with that function is small, according to a former SEC official who spoke on condition that he not be named because of the firestorm over the agency's lack of oversight.

"In retrospect, we were in error to think that we had a system which could regulate and monitor and constrain irresponsible behavior on Wall Street," said Samuel L. Hayes, professor emeritus at Harvard Business School and a specialist in capital markets. Now, he said, "We have to go back to the drawing board and really reconstruct a regulatory framework that takes into account 21st-century realities."

Beth Healy can be reached at bhealy@globe.com.