Judge Rakoff Demonstrates What Having Guts Looks Like

Citigroup made shameful and dangerous decisions. It should have to explain itself.

On the whole, I have suggested a somewhat bleak view of our political system and our future prospects. But when there are moments and people to celebrate I want to do so. And we should all celebrate Judge Jed Rakoff. (As full disclosure, Judge Rakoff is a friend, and was a graduate school classmate at Oxford.)

On Monday this week, Judge Rakoff rejected an SEC offer to settle a securities fraud case against Citigroup that entailed a $285 million payment by Citigroup but not any admission of fault or wrongdoing. Judge Rakoff said the settlement terms were “neither fair, nor reasonable, nor adequate, nor in the public interest.”

This decision complicates the SEC’s life, and I would imagine that Citigroup is absolutely dead-set against acknowledging wrongdoing. But what Citigroup and other financial institutions did was wrong at a micro and a macro level and should not be glossed over.

First, what’s at issue? Citigroup created a class of securities, Class V Funding III, which consisted of bundled mortgage-backed securities (in the industry jargon they are referred to as “negatively projected,” i.e. they aren’t going to be worth much), then sold these securities to investors, and then bet against their own securities (and their own investors). Judge Rakoff adds some color to this: “This (Citigroup’s ability to ‘dump dubious assets on misinformed investors’) was accomplished by Citigroup’s misrepresenting that the Fund’s assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negative projected assets and had then taken a short position in those very assets it had helped select.”

Citigroup made about $160 million on its transactions. Investors eventually lost about $700 million. This stinks.

At a micro level, Citigroup’s blithe willingness to do this is terrifying. For example, I sit on the investment committee of a medium sized foundation. As it happens, we would never make this kind of investment, but someone similar to us could easily have done so. If we had considered this, do you think Citigroup or the broker or the sales person would have told us what these investments really were? Of course not. Someone could have — and, obviously, people did — invest in these securities thinking they were making a reasonably safe investment, not knowing that they were purposely designed to blow up. I haven’t counted, but my sense is that a lot more players than Citigroup did this — so whom can you trust?

This gets to the core of what’s wrong at the macro level. Citigroup’s decisions to design, sell, and short these securities are not ones respectable and responsible business people should make. They erode trust, they are corrosive, and they are dishonest. One of the main functions of our kind of financial system is intermediation, but if the mediators see the investors as prey, and are allowed to do so, then the system isn’t working. This is why the Volcker rule makes sense. And Citigroup’s CEO and board should be ashamed of themselves. They should have to explain why they believe there was no fault or wrongdoing here.

The economy is miserable. The political system is in gridlock. The super committee has just demonstrated that Congress can’t accomplish anything. But on this big issue, Judge Jed Rakoff made a gutsy, and correct, decision.

Roosevelt Institute Senior Fellow Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team. He has also served in senior roles in the White Houses of two Democratic presidents.

Cross-Posted From The Roosevelt Institute’s New Deal 2.0 Blog

The Roosevelt Institute is a non-profit organization devoted to carrying forward the legacy and values of Franklin and Eleanor Roosevelt.

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