The Price of Inequality: How Today's Divided Society Endangers Our Future (32 page)

In fact, the system we had in place made it easy for them to get away with these shortcuts—at least until there was a popular uproar. In most states, homeowners could be thrown out of their homes without a court hearing. Without a hearing, an individual cannot easily (or at all) forestall an unjust foreclosure. To some observers, this situation resembles what happened in Russia in the days of the “Wild East” after the collapse of communism, where the rule of law—bankruptcy legislation in particular—was used as a legal mechanism to replace one group of owners with another. Courts were bought, documents forged, and the process went smoothly. In America, the venality operates at a higher level. It is not particular judges who are bought but the laws themselves, through campaign contributions and lobbying, in what has come to be called “corruption, American-style.” In some states judges are elected, and in those states there’s an even closer connection between money and “justice.” Monied interests use campaign contributions to get judges who are sympathetic to their causes.
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The administration’s response to the massive violations of the rule of law by the banks reflects our new style of corruption: the Obama administration actually fought
against
attempts by states to hold the banks accountable. Indeed, one of the federal-government controlled banks
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threatened to cease doing business in Massachusetts when that state’s attorney general brought suit against the banks.

Massachusetts attorney general Martha Coakley had tried to reach a settlement with the banks for over a year, but they had proved intransigent and uncooperative. To them the crimes they had committed were just a matter for negotiation. The banks (she charged) had acted both deceptively and fraudulently; they had not only improperly foreclosed on troubled borrowers (citing fourteen instances), relying to do so on fraudulent legal documentation, but they had also, in many cases, promised to modify loans for homeowners and then reneged on the promise. The problems were not accidental but systematic, with the MERS recording system “corrupting” the framework put into place by the state for recording ownership. The Massachusetts attorney general was explicit in rejecting the “too big to be accountable” argument: “The banks may think that they are too big to fail or too big to care about the impact of their actions, but we believe they are not too big to have to obey the law.”
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In late February 2012, the
Wall Street Journal
uncovered another unsavory aspect of America’s foreclosure crisis. Just as we noted in chapter 3 that there had been discrimination in the issuance of mortgages, so too in the foreclosure process—this time not on the basis of race but on the basis of income. On average, it took banks two years and two months to foreclose on mortgages over $1 million, six months longer than on those under $100,000. There were many reasons for this, including banks’ exerting greater efforts to accommodate these big debtors and borrowers’ being better armed with lawyers to defend themselves.
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The discussion of this chapter, along with that of chapter 6, has shown how the financial sector made sure that the “rule of law” works in its favor
almost always
, and against ordinary Americans. It has the resources, the organization, and the incentives to do so; and it accomplished what it set out to do, through a multifaceted attack that included reforming bankruptcy laws to increase their power over borrowers, ensuring that private, for-profit schools could get access to student loans, almost regardless of standards, abolishing usury laws, preventing legislation to curtail predatory lending, and circumventing the procedural safeguards, weak as they were, to make sure that only individuals who really owed money would lose their homes. But in lending and in foreclosures they targeted the weak, the poorly educated, the poor. Moral scruples were set aside in the grand quest to move money from the bottom to the top.

In chapter 6 we explained how the foreclosure crisis could itself have been largely avoided, if we had only not let the banks have so much influence, by allowing an orderly restructuring of debt, just as we do for large corporations. At each step of the way, from the initial making of loans to the final foreclosure, there were alternatives and regulations that would have curtailed the reckless and predatory lending and enhanced economic stability—perhaps even avoiding the Great Recession itself—but with a political system where money matters, these alternatives had no chance.

The mortgage debacle and the persistence of predatory lending and bankruptcy “reform” have raised deep questions about “the rule of law,” which is the universally accepted hallmark of an advanced, civilized society. The rule of law is supposed to protect the weak against the strong and ensure fair treatment for all. In the wake of the subprime mortgage crisis, it has done neither. Instead of a rule of law that protected the weak, we had laws and regulations and a system of enforcement that further empowered the already powerful banks. In moving money from the bottom to the top, they worsened the problems of inequality in both tails of the income and wealth distribution.

D
E
F
ACTO VS.
D
E
J
URE

Running a judicial system is costly, and the rules of the game determine how large those costs are and who bears them. If one designs a costly system in which the parties themselves bear the cost, then one is designing an unfair system, even if in principle it seems otherwise. If one designs a slow judicial system, that too can be unfair. It’s not just that “justice delayed is justice denied,” but that the poor can’t bear the costs of delay as well as the rich. Corporations know this. In their negotiations with less wealthy opponents a standard tactic is to make a small up-front offer and threaten to impose a long and costly process with an uncertain outcome if the offer is not accepted.
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Even access to the legal system is expensive, and that gives an advantage to large corporations and the wealthy. We talk about the importance of intellectual property, but we have designed an expensive and unfair intellectual property regime that works more to the advantage of patent lawyers and large corporations than to the advancement of science and small innovators.
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Large firms can trespass on the intellectual property rights of smaller ones almost with impunity, knowing that in the ensuing legal fight they can outgun them. Rogue patent trolls (law firms) can buy sleeping patents (patents that have not yet been used to bring products to the market) at a low price, and then when a firm is successful in the same field, claim trespass, and threaten to shut it down as a form of extortion.

That’s what happened to Research in Motion, the producer of the popular BlackBerry, which became the target of a patent suit from “patent-holding company” NTP, Inc. That company is currently also in litigation involving Apple, Google, Microsoft, Verizon Wireless, AT&T, Yahoo! and T-Mobile USA.
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It wasn’t even clear whether the patents that were supposedly infringed were valid. But until their claims are reviewed and declared invalid—which may take years and years, the “owners” of the patent can shut down any firm that might trespass, unless it pays
whatever
fee and accept
whatever
conditions are imposed upon it, including the condition that the patent not be challenged. In this case, BlackBerry gave in to the demands and paid more than $600 million to NTP.
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More recently, the cell phone industry has engaged in a tangle of patent disputes (involving Apple, Samsung, Ericsson, Google, Microsoft, Motorola, Nokia, RIM, LG, HP, and a patent holder, Acacia Research Corporation), in a variety of legal forums in different countries. While the outcome is uncertain—if certain parties win, the range of choices consumers face may be dramatically reduced and prices increased—what is certain is that the big winners in these battles will be the lawyers.

The legal system itself extracts large rents, as we noted in chapter 2. The big legal battles to enforce the laws that exist—say, over whether Microsoft violated the laws designed to maintain a competitive marketplace or whether the banks committed fraud—entail battalions of lawyers. There has been an arms race; and it’s an arms race in which the banks that engage in fraud or the firms that engage in anticompetitive practices have the big advantage, especially since private firms do what they can to circumscribe government’s ability to spend. The consequence is illustrated by how the Securities and Exchange Commission has pursued repeated occurrences of fraud by America’s banks.

The SEC and securities fraud

I have described how the banks tried to take advantage of ordinary homeowners in the mortgage market. The banks tried to take advantage of the more financially sophisticated as well. The SEC (the U.S. Securities and Exchange Commission, which is in charge of enforcing the federal securities laws) has repeatedly brought civil enforcement actions against Citibank and other major banks for violations of the fraud laws.

What happens after that has generally followed this path: The banks threaten a never-ending legal battle. Compromise follows: the banks pay a large fine, neither admitting nor denying guilt. They also promise never to do such a thing again. But soon after their promise, they engage in similar behavior again. Then they incur another scolding and a fine they can afford.

It’s a convenient solution: the government has limited resources to prosecute legal cases, and there are many instances of fraud. Having reached a settlement on one, the government can then go on to attack another. The system also suits the banks: the cost is low relative to the profits they reap from their fraudulent behavior, and, had they admitted guilt, the evidence could have been used against them in private litigation brought by those the fraud injured in their attempt to recover their losses. The banks know that most of their victims don’t have the legal resources to challenge them without the government’s help. No one can claim that justice is really being done in this system. An economic system in which there is a pattern of such abuses can’t work well: fraud distorts the economy and undermines trust.

A court has to approve the SEC settlements, and the courts typically approve them pro forma. But for one judge the level of fraud finally proved too much. In late November 2011, Judge Rakoff of the U.S. District Court in Manhattan rejected a proposed $285 million settlement from Citigoup on a fraud charge. He noted that the bank had been a repeated offender, a “recidivist.” It was clear that the SEC enforcement actions were having little effect on its behavior, partly because the SEC didn’t bring contempt charges against repeated offenders like Citibank for violating their promises.

In this case, Citibank (like many of the other banks, including Goldman Sachs) had constructed securities consisting of mortgages that it believed would fail, partly so that it (or, in the case of some other banks, favored customers) could bet against the securities. When the values declined, the bank (or its favored customers) made huge profts at the expense of the bank’s clients who purchased the securities. Many of the banks didn’t disclose what they were doing. One variant of their defense was caveat emptor: “No one
should
trust us, and anyone who does is a fool.” But in the case whose settlement Judge Rakoff rejected, Citibank and some of the other banks had gone beyond keeping silent on the risks: they had falsely told investors that an independent party was choosing the portfolio’s investments. While investors lost $700 million in the deal, Citibank made $160 million.

If this were an isolated instance, it could be blamed on a few individuals. But the
New York Times
, in an analysis of SEC fraud settlements, “found 51 instances, involving 19 companies, in which the agency claimed that a company had broken fraud laws that they previously had agreed never to breach.”
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It would seem we have an economic and legal system that provides incentives for bad behavior: the executives’ pay goes up when profits go up, even if the profits are based on fraud; but the company’s shareholders pay the fines. In many cases the executives who were responsible for the fraudulent behavior have been long gone. There is something to be said here for criminal prosecutions against executives. If the shareholders pay the fines, and management pays itself compensation based on short-term performance and hiding risks in the tails of the return distribution (the events that occur with small likelihood, like getting caught, prosecuted,
and
fined), we shouldn’t be surprised at these persistent patterns of fraud. In such circumstances, we have to go beyond fining the company: it is people who make decisions and take actions, and they should bear responsibility for their actions. Those who commit these crimes can’t just shift their accountability to an abstract entity called the “corporation.”

C
ONCLUDING
C
OMMENTS

The need for a strong rule of law is widely accepted, but it also matters what kind of rules there are and how they are administered. In designing the system of laws and regulations that govern an economy and a society, there are trade-offs: some laws and regulations favor one group, others another.

We have examined several examples where what has happened was perhaps predictable: the laws and regulations, and how they are implemented and enforced, reflect the interests of the top layer of society more than those of the people in the middle and at the bottom.

Growing inequality, combined with a flawed system of campaign finance, risks turning America’s legal system into a travesty of justice. Some may still call it the “rule of law,” but in today’s America the proud claim of “justice for all” is being replaced by the more modest claim of “justice for those who can afford it.” And the number of people who can afford it is rapidly diminishing.