Why the inside-trading crackdown misses the mark

COMMENTARY Why is the U.S. government training its fire on insider traders, while letting financial executives who committed fraud before and after the housing crash go scot-free?

On the one hand, federal prosecutors are to be commended for their widening investigation into what Manhattan U.S. Attorney Preet Bharara calls a "criminal club" involving hedge-fund managers who allegedly paid corporate executives for confidential information. As he said on Wednesday when charging seven people in connection with the probe:

We have demonstrated through our prosecutions that insider trading is rampant and has its own social network, a network we intend to dismantle. We will be unrelenting in our pursuit of those who think they are above the law.

Hear, hear. Insider trading is theft, usually of information. It is a way of rigging the game, and it undermines confidence in the financial system. But why is there no relentless pursuit of executives who took part in what amounts to a far bigger conspiracy -- knowingly selling billions of dollars in fraudulent mortgage loans and securities? Instead, the feds have repeatedly opted against prosecuting individuals implicated in these crimes in favor of limp legal settlements that history shows have no deterrent effect, let alone a whiff of justice.

Bharara, and presumably others in the Obama administration, are clearly aware of the inconsistency. That is why he apparently felt obliged yesterday to distinguish the "big short" -- an allusion to Wall Street banks betting against the same mortgage-backed securities that they were peddling to investors -- from what he dubbed the "big illegal short" in referring to the kind of malfeasance committed by insider-traders.

Nice try. Banks like Goldman Sachs (GS) and Citigroup (C) didn't simply short the housing sector -- they defrauded their own clients, as federal judge Jed Rakoff underscored last fall in nixing a $285 million settlement between the SEC and Citi over the banking giant's securitization practices. And not to the tune of $61 million, which is how much Bharara says the seven investment pros charged in the latest insider-trading sweep made from their illegal activities, but many billions of dollars in profits, bonuses, commissions and other ill-gotten gains.

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There are several theories behind why the government has failed to bring criminal charges against high-profile financial execs. One, proffered not only by bankers but by President Obama himself, is that no crimes were committed.

This view is at odds with reality. Fraud was rampant during the bubble years and persists to this day. Here's a short list of such deeds: Mortgage firms faked loan applications, misrepresenting borrowers' income and job status; lenders steered borrowers with good credit into pricier subprime loans; bankers packaged vast numbers of what they knew to be dodgy loans into collateralized debt obligations and sold them to investors; bankers conspired with favored investors to design self-annihilating mortgage securities that could be sold to other investors; financial firms misled investors about the risks on their balance sheets, resulting in huge shareholder losses; and banks took kickbacks from mortgage insurers, even colluding with the firms to gin up phony reinsurance agreements.

How do we know fraud was so prevalent? For one, because the companies that engaged in it have tried hard to squash evidence of their chicanery. From General Electric (GE), where ex-employees say they were punished for ferreting out mortgage fraud, to JPMorgan Chase (JPM), which recently settled a suit filed by a former assistant vice president who accused the company of firing her after she discovered that Chase was illegally "robo-signing" documents used to collect credit-card debt, big financial players have sought to shovel dirt over the grave.

A related explanation for why the feds have shied away from going after bankers is that the kind of fraud committed during the housing bubble is too arcane for judges and juries to comprehend. Not really. Although some of the financial instruments used to perpetuate the fraud are complex, the intent behind selling such securities was clear, especially when that required passing bad paper to investors. However labyrinthine the structure of a CDO, in other words, there is nothing mysterious about Citi teaming with select investors to hawk toxic assets to less favored customers.

Besides, a schoolkid can understand much of the fraud at the heart of the financial crisis. Take failed thrift Washington Mutual, which blew up in 2008 in one of the biggest corporate bankruptcies in U.S. history. One instrument of deception? Wite-Out, which loan personnel used to fake mortgage applications. As Thomson Reuters columnist David Cay Johnston writes:

Show a jury falsified records and bald-faced lies in disclosure documents, then toss in testimony from insiders who pointed out the wrongdoing only to be told to shut up -- or who got fired -- and convictions follow.

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There will be no such reckoning for former WaMu leaders. In December, the FDIC agreed to a $64.7 million settlement with the lender's ex-CEO, Kerry Killinger, and two other former execs. Of that amount, Killinger, whose total compensation at WaMu between 2003 and 2008 approached $100 million, must pay $275,000 (and forfeit $7.5 million in retirement money).

The government's aversion to prosecuting bankers isn't confined to the Obama regime, of course. The Justice Department's policy of using so-called deferred prosecution deals, in which companies agree to pay a fine and vow to follow the law (until the next time), dates back at least to 2003. Corporate interests have been consolidating their power in this country for a long time. But it is the current tenant at 1600 Pennsylvania Avenue who is whiffing on a historic opportunity to reassert the rule of law in our troubled financial system.

Without that, it's worth remembering, we're all outsiders.