Many commentators have remarked that 2008 will be known as the modern financial system's annus horribilis. (2) Certainly, the current upheaval in the financial markets is unprecedented. Assumptions about the U.S. financial system that have gone unquestioned since the Great Depression have been shown--in some cases overnight--to be invalid. Former pillars of the financial community have collapsed, been taken over, or been humbled into begging for federal government aid as part of the Troubled Assets Relief Program ("TARP"). (3) Economists are predicting the current recession likely will be the worst since the 1930s. (4) And across the country, citizens are asking angrily how this happened and who is to blame.
Amidst this wreckage, as legislators consider proposals for sweeping regulatory reforms, prosecutors and regulatory agencies have begun the arduous and time-consuming process of determining whether any criminal wrongdoing led to the credit crisis. (5) The fundamental question that prosecutors and regulators face is whether the breakdowns in the American financial system--such as the pandemic of mortgage defaults, writedowns on structured products, massive plummeting in financial institutions' stock prices, and the failures of some of those institutions--were caused by intentional or reckless misconduct, or whether they were simply the result of errors in business judgment. This question will occupy criminal and regulatory enforcement for the coming years. If these breakdowns were the result of criminal misconduct, wrongdoers may face prosecutions and other regulatory sanctions; if, however, the breakdowns were caused merely by poor business decisions, sanctions will be more appropriately limited to the extensive media criticism corporations and executives have already received.
This article surveys the various facets of the credit crisis, the responses of federal and state prosecutors and regulators, and the challenges law enforcement faces in addressing the problems that have arisen in the financial system. Law enforcement agencies have been essentially reactive to these problems, even as they have publicized their efforts extensively. For example, at the federal level, the first credit crisis investigations, into the issuance of subprime mortgages, (6) were initiated after several subprime mortgage lenders began to report large losses due to widespread mortgage defaults. (7) Federal regulators then shifted their focus to Collateralized Debt Obligations ("CDOs") (8) after leading financial institutions announced massive writedowns arising from their exposure to these complex products. After the collapse of several of these institutions, including Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and Washington Mutual, federal regulators shifted their attention to investigating the accuracy of the companies' public disclosures regarding liquidity and asset valuations. (9) And when allegations surfaced that illegal short selling had contributed to the precipitous stock price drops preceding some of these institutions' collapse, short sellers became the primary regulatory focus. (10)
The same reactive pattern has occurred at the state level. Accusations that deceptive and fraudulent lending practices had contributed to widespread subprime mortgage defaults led state regulators to investigate predatory lending at major mortgage lenders. (11) After the leading credit rating agencies announced downgrades on securities backed by subprime mortgages in July 2007, causing a steep drop in the prices of many equity and fixed income securities, state regulators began investigating the propriety of the procedures agencies had used in rating mortgage-backed securities. (12) And when the credit crisis spread from the mortgage-backed securities market to the auction rate securities ("ARS") market in early 2008, state investigations of ARS issuers followed. (13) In all of these areas, ex ante regulation failed to prevent the financial crisis, and state and federal agencies have been playing catch up ever since. …