How Wall Street is like a corrupt police department

“The similarity between police corruption and stock-market corruption is drug dealers with unlimited money to spend. They can make their own law.”
~John Bogle

(Portfolio) Tracing The Roots Of Corruption/Preventing The Next Madoff. What the crackdown on police corruption can teach us about scandals on Wall Street: No doubt about it, this latest Wall Street scandal season has been lush and prolific. It began with the subprime meltdown in the spring, then brought the failures of Bear Stearns and then Lehman Brothers last fall, and has culminated with the $50 billion fraud of Bernie Madoff, a sort of long, dark winter.

And so it goes throughout time. “It’s a roughly 20-year cycle,” which basically coincides with market crashes, says John Steele Gordon, author of The Great Game, a history of Wall Street’s first three and a half centuries. Seven years before our current misery came Enron and the analyst scandals. Before them, Drexel Burnham Lambert and Michael Milken, which followed Equity Funding and other scandals in a series stretching back to the Dutch tulip mania of the 1630s and probably beyond.

If this sounds hopeless, it’s because that’s exactly what it has been. The accepted wisdom is that financial scandals are an inevitable by-product of greed and human frailty—or even the price we pay for a wide-open system that supposedly gives Wall Street its competitive edge over the rest of the world. “Greed will always be with us,” says Lee Kjelleren, CEO of the Museum of American Finance, in Lower Manhattan. “We’re not going to change that.”

Except that maybe we can. Instead of accepting the scandals with resignation, what’s needed is a radically new way of looking at the problem. No more endless cycle of scandals. As a start, Wall Street should no longer be viewed as a fundamentally sound institution that occasionally runs off the track. Instead, try thinking of it as a police department in which far too many officers are on the take.

Lawrence Sherman has been studying police corruption for most of his life. Sherman, a criminologist at Cambridge University and the University of Pennsylvania, is the author of a seminal 1978 study, Scandal and Reform, that looks at a period that was as dark for the nation’s law-enforcement community as the current moment is for Wall Street.

Like financial crime is now, police corruption was then everywhere: systemic, pervasive, and difficult to uproot. The New York City Police Department, for instance, suffered from a widely acknowledged 20-year cycle of scandal, fed by organized crime and an institutional culture that encouraged dishonesty. Sherman says that cycle was broken by a combination of factors, including public outrage and a city-government commitment, that resonate today with regard to Wall Street, largely because of their absence.

John Bogle, the founder of the Vanguard Group of mutual funds, is among those who think the comparison is apt. Indeed, Bogle goes one step further, blaming bankers and traders for partly causing Wall Street’s cycles to continue. “Not to draw an analogy that’s going to make me even less popular than I am,” Bogle says archly, “but the similarity between police corruption and stock-market corruption is drug dealers with unlimited money to spend. They can make their own law.”

Until recent years, systemic corruption was a persistent issue for police forces nationwide, with cops taking payoffs from drug dealers and gamblers. The corruption was organized and institutional. It seemed so ingrained that it could not possibly be fixed. But it was—in the cities that chose to address it.

Those cities approached their corrupt police forces not as a collection of “bad apples” but as organizations that had gone off the rails. Sherman calls those forces “deviant,” in that they bypass social norms and laws “in order to achieve societally legitimate organizational goals”—bending the rules, in other words, but doing so with decent intentions.

That’s about as good a clinical diagnosis of the problem on Wall Street as one can find. Think about the scandals of the past year—the buildup of leverage, subprime paper, questionable accounting—that doomed major Wall Street firms. Their goal was to achieve profits and bonuses, legitimate aims that our society encourages. But their means deviated from social norms: By disregarding the fundamental principles of risk management, or by ignoring the stretched finances of well-intentioned homeowners trying to buy a bigger house than they could afford, these companies endangered not only themselves but the financial system as a whole.

A second variety of organizational deviants identified by Sherman—the ones with “goals that are deviant from societal norms or laws”—is the group Madoff obviously belongs to, as do the deceitful boiler-room
subprime-lending operators that encouraged people to lie on their mortgage applications to get the deals done. Sam Antar, a convicted securities swindler, believes people like Madoff often don’t set out to become criminals. “He just started the scam and then it built on itself and he couldn’t get out,” suggests Antar, who served as chief financial officer of consumer-electronics retailer Crazy Eddie in the 1980s, when it was involved in several fraudulent schemes; now he lectures law enforcement on how to prevent white-collar crime.

Police corruption thrives when the watchdogs—the municipal government and the senior police officials—are indifferent or ineffective. Antar says the parallels with the Securities and Exchange Commission are compelling. The failures of its enforcement staff, starved for resources under chairman Christopher Cox, mirror the inability in past years to confront police corruption. Those failures were documented by Sherman and chronicled in such books as Robert Daley’s Prince of the City and Peter Maas’ Serpico, the story of a whistleblower (played by Al Pacino in the 1978 film) who fought NYPD corruption. Recently, the SEC’s handling of whistleblowers has also come under scrutiny because of the way it ignored Harry Markopolos, who had tried again and again since 2000 to call the agency’s attention to Madoff and his family.

These attitudes have parallels in the street code of cops to keep silent about corruption in their ranks and to ostracize “rats.” Cox’s famous pre-meltdown verdict on Bear Stearns—“We have a good deal of comfort about the capital cushions that these firms have been on,” he told Congress—seems mind-boggling in retrospect, but it is in keeping with a police chief defending the integrity of his officers. Antar, who spent his formative years cooking books two decades ago, told me that if Cox was on the job back then, “I would still be in business as the criminal CFO of Crazy Eddie today.”

No fight against police corruption has ever been successful without an unsparing examination of the problem. Currently, the details of what happened on Wall Street remain murky. The decision not to bail out Lehman Brothers is clouded in haze, with conflicting accounts leaking out of the U.S. Treasury Department and the Federal Reserve. What triggered the demise of Bear Stearns and Lehman continues to be disputed. The SEC’s only palpable response to the crisis was a crackdown on shorting—which Cox later called the biggest mistake of his tenure. The action, he said in December, was taken under pressure from Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke.

Over the years, 9/11-style commissions have been created to probe such issues and events as the John F. Kennedy assassination, the attack on Pearl Harbor, violence in America, and the Challenger space-shuttle explosion. Surely the banking and regulatory practices that threw the country into a recession deserve the same kind of analysis, probably from an agency with more teeth than the Bush-era SEC.

Launching just such an investigation would give President Obama an opportunity to prove that his campaign slogans about change also apply to the financial world. “Obama has everything to gain by appointing a commission that will propose bold restrictions on the business community,” Sherman says. But he concedes that “there’s a lot of competition out there for being the originator of ­proposals to introduce a reform package for Wall Street.”

In the 1970s, when municipalities were grappling with corruption that had been around for generations, it became apparent that merely punishing past corrupt acts didn’t work. What did work were policies and intelligence-gathering efforts that anticipated the corruption.

When it comes to Wall Street, the SEC and other regulators tend to address wrongdoing after the fact, sometimes years later. That was the agency’s defense in response to accusations that it did nothing to catch Madoff, and in a way, it had a point. The SEC is not set up to conduct investigations ahead of time. It comes in afterward and deals with securities-law transgressions, in most cases through “consent decrees” in which corporate or banker defendants pledge not to repeat offenses they didn’t admit to committing in the first place. The agency’s aim is to eliminate the need for costly litigation while still deterring other possible offenders.

The problem is that punishing people for financial crimes they’ve already committed doesn’t work. Ernest Poortinga, staff psychiatrist at the Michigan Center for Forsenic Psychiatry, tells me that an exhaustive study of white-collar crime found that “there’s absolutely no difference between white-collar criminals and common thieves, other than the opportunity.” The three-card-monte dealer in the park can’t start a Ponzi scheme—but only because he’s not running a Wall Street firm with a lot of naive investors eager to give him money. The law-enforcement approaches toward the two criminal types should be the same.

People like Madoff don’t think about punishment, much less the “threat” posed by an SEC bureaucrat finding out about them. “They don’t think they’re going to get caught,” Poortinga says. Ex-crook Antar says Madoff had no reason to think he would get caught, despite the examples provided by Ken Lay, Dennis Kozlowski, and others. “Once you take from Peter to pay Paul, there’s no way out; it keeps on pulling you back in and you’re stuck,” Antar says. And to actually pull off a scam like Madoff’s takes a degree of self-confidence that makes one heedless of the threat of consequences, he notes. “There is an arrogance to being a criminal that most people don’t possess,” Antar says. “That’s why criminals don’t think they’re going to get caught. It’s a bit like a speeding ticket. People see the cop and slow down, but then they speed up again.”

The SEC has recognized the need to be preemptive—on paper. In 2004, the agency established the Office of Risk Assessment, whose purpose was “to develop new ways to process and analyze information in order to properly assess market risks associated with an increasingly complex market environment.” The problem is that the office, which began with seven people, had withered to a grand total of one staff person by February 2008, when the SEC announced an “expansion.” Today, it again has seven employees, although they are part of a group of 37 people agencywide looking at preventing future crimes.

Financial firms need to suffer some harsh consequences for past, present, and future violations of the public order. Statistics have shown that effective police reform required that large numbers of corrupt police officers were quickly, and publicly, dismissed. Dealing with Wall Street, however, will require something a bit different. After all, many of the executives responsible have already lost their jobs (as have thousands of nice young kids with MBAs and student loans to repay). The worst of them will probably be prosecuted—but that doesn’t really matter, as we’ve seen that punishment does not deter financial wrongdoing. Jail sentences will no doubt be handed to the most egregious offenders in the subprime crowd and to Madoff, assuming he doesn’t somehow beat the rap.

We need to put in place an incentive that will change the way Wall Street behaves. Financial penalties should be increased so that the kind of pain we’ve experienced is shifted to the banks if they screw up again. When a bank or a hedge fund violates the public trust in a major way, fines should be expressed not in dollars but as a percentage of annual revenue or profit, on an escalating scale. If companies can’t afford to pay the fine, they can be nationalized, as has happened in Europe with far less provocation.

If anything can pull us out of the doldrums, perhaps it’s the fact that institutions far nobler than Wall Street have faced corruption for a very long time and still managed to put a stop to it. While Sherman was working on his book in Britain in the 1970s, firms involved in supplying the Royal Navy were prosecuted for kickbacks. “When the arrangements were researched,” he recalls, “it turned out that it had been going on since the 18th century.” (source)