Addressing Recent Wall Street Misconduct Requires The SEC to Adopt Creative Approaches


Citigroup and the U. S. Securities and Exchange Commission (SEC) are discussing possible settlement of an investigation into whether Citigroup overvalued billions of dollars of subprime mortgage-backed securities on its books in the latter part of 2007, according Susan Pulliam and Randall Smith of the Wall Street Journal in a May 28, 209 article entitled “Citi, SEC Are in Talks to Settle Probe.” The investigation followed a series of events that led to the resignation of CEO Charles Prince and the reporting of approximately $50 billion in overall losses, mostly due to its subprime mortgage-backed holdings. In October 2007, Citigroup reported a $1.83 billion loss of value in its subprime mortgage-backed securities. Weeks later, Citigroup reported that the loss of value was more like $8 to $11 billion, and also that it held far more subprime mortgage-backed securities than it had previously reported. The investigation centers on the validity of Citigroup’s valuation methods and whether it misled the investing public when there was no market to set prices for these non-conventional and complex assets.

The Citigroup investigation is one of a series of investigations launched by the SEC into the securities valuation practices used by Wall Street firms in valuing exotic, thinly traded derivative and structured finance securities. Merrill Lynch, Lehman Brothers, Bear Stearns and many others are among those subject to the investigations.

The talks may signal that the SEC is trying to wrap up these investigations. SEC settlements typically involve the payment by the firm of a civil monetary penalty. There is concern both inside the SEC and by outside observers that fines would be meaningless under the circumstances where Citigroup has received $45 billion in taxpayer bailout funds from the Troubled Asset Relief Program (TARP). The article quotes one observer: “Is the money being round-tripped, going from one part of the government to another part?” And how does that square with the government’s purpose of bolstering the firm’s capital so it can function in the marketplace?

The problem is: the government’s intentions to both bailout and penalize the firms are contradictory. This is called a paradox. Common sense says that when you have a paradox, there is something wrong with a least one of the premises. People close to the situation say that the SEC is also considering bringing cases against individuals, including top executives, for their individual wrongdoing. Now that would seem to solve the paradox. By penalizing the individuals in a position to engage in and oversee wrongdoing, the SEC could dissuade others from engaging in similar wrongdoing without compromising the rescue efforts.

Similarly. the government could require that Citigroup and other culprits publicly admit their misconduct and simultaneously enter into deferred prosecution agreements whereby the companies would not be criminally prosecuted unless they acted inappropriately again.