Banks get ready to feel the penalty pain

“Half a billion dollars is the largest penalty ever assessed against a financial services firm in the history of the SEC,” crowed the regulator’s head of enforcement three years ago as he announced a landmark settlement with Goldman Sachs.

That $550m agreement between Goldman and the Securities and Exchange Commission for allegedly misleading investors in structured mortgage products then stood as an isolated mountain in the landscape of enforcement actions. Now, it is a foothill in a much grander range.

“I would say we’re not in a new world, we’re in a new universe,” says one senior bank lawyer. “This has radically changed and it has changed because the penalties are exponentially higher.”

JPMorgan Chase is the new whipping boy for regulators, succeeding Goldman as the totem of Wall Street excess – from its traders’ ability to lose billions on derivatives and their alleged attempts to cover it up or allegations that the bank hired relatives of Chinese officials to win business.

The biggest single amount may end up being a suit against JPMorgan from a government housing regulator that, as the Financial Times revealed this week, is now seeking more than $6bn compensation for mortgage securities it sold that declined in value during the financial crisis.

JPMorgan is resisting that amount. But it can, nonetheless, afford it, having made more than $6bn of net income last quarter. That is perhaps the problem for the whole industry, according to some bankers. Regulators might feel more confident of demanding searing fines from banks that can pay up without fear of shutting down.

Though the largest US banks have reserved more than $100bn between them for legal costs since the crisis, analysts are now concerned that reserves may be insufficient for the latest surge.

“To the extent that the settlements are coming in higher than the banks expected and the Street expected, I think you’re going to have additional reserves,” says Charles Peabody, analyst at Portales Partners. With JPMorgan’s swelling legal storm, there will be additional charges soon, he says, hitting income: “You’re talking a $2bn-plus number in the third quarter.”

To those who think Wall Street has been inadequately punished for its role in the financial crisis and the aftermath, the latest levies on the industry are progress but still insufficient. “It’s a substantial step-up but that’s because in the last 10 years they’ve got away with murder,” says Dennis Kelleher, head of Better Markets, which campaigns for tougher financial regulation. “The global banks have been on a crime spree for a decade with the so-called market police just ignoring them,” he says. “Relative to the ill-gotten gains and the damage that they’ve inflicted they [the penalties] are not substantial.”

What both sides can agree on is that as public outrage over bank conduct grew – along with frustration at the lack of accountability for individuals – so did the fines. In June 2012 Barclays paid £290m and signed a non-prosecution agreement with the US government to resolve allegations the bank rigged the London interbank offered rate, a key benchmark interest rate.

You see somewhat of a stiffening of the DoJ and SEC posture in some of these cases. Some of it is in response to the facts in the investigation, some might be in response to the criticism of insufficient zeal

British members of parliament were appalled by the detailed allegations of misconduct and the backlash helped force the resignation of Bob Diamond as Barclays’ chief executive.

Later that year the US Department of Justice reached a settlement with HSBC covering a long list of criminal activity, including laundering money for drug lords in Mexico from 2006 to 2010 and evading US sanctions by processing financial transactions with prohibited countries from the 1990s to 2006.

HSBC paid $1.26bn and signed a deferred prosecution agreement. Lanny Breuer, then the assistant attorney-general for the Department of Justice, held a press conference in New York only to be hectored by reporters demanding to know why the bank had been spared a prosecution. Charles Grassley, the Republican senator from Iowa, blasted the DoJ for its “inexplicable unwillingness to prosecute and convict those responsible for aiding and abetting drug lords and terrorists”.

The criticism that banks were “too big to jail” resonated within the DoJ, which for five years has battered back criticism for not bringing any criminal cases against financial institutions for their role in the credit crisis.

Eight days after HSBC’s settlement, the DoJ significantly toughened its tactic by requiring the Japanese subsidiary of UBS to plead guilty to wire fraud to settle allegations the Swiss bank manipulated Libor and other benchmark interest rates. UBS paid $1.5bn and signed a nonprosecution agreement.

When Royal Bank of Scotland sought to settle Libor charges in February the terms were equally tough. The bank agreed to pay $612m and one of its Asian subsidiaries pleaded guilty to wire fraud.

Lenders face threat of ‘gigantic’ legal costs

A lawsuit launched two years ago to demand compensation for soured mortgage securities has emerged as the biggest legal threat to many of the world’s largest banks.

After a series of defeats in court and a couple of large settlements, banks are fearing unprecedented costs from the US government’s attempt to recoup tens of billions of dollars from them.

“You see somewhat of a stiffening of the DoJ and SEC posture in some of these cases,” says Daniel Richman, a former federal prosecutor and now professor of law at Columbia University. “Some of it is in response to the facts in the investigation, some might be in response to the criticism of insufficient zeal.”

There is something else common to many of these banks: for all JPMorgan’s troubles, many of the other punished parties are not American. One US bank lawyer says: “Foreign banks have been dinged by domestic regulators and prosecutors now and at some point a foreign regulator is going to say, ‘we’re tired of our banks being home-turfed in the United States and we’re getting even’.”

Back in the US, President Barack Obama announced in January 2012 the formation of a task force to investigate misconduct by banks selling residential mortgage-backed securities. The first civil case was filed earlier this year against Standard & Poor’s for allegedly issuing inflated ratings for RMBS and collateralised debt obligations.

Lawyers involved in the investigations say the DoJ is seeking fines against nearly every financial institution, large and small, that touched the mortgage process. They also say that banks are turning over the same documents, records and testimony they have provided in previous investigations.

With different regulators dishing out penalties for the same offences and the marked upswing in size, banks complain they have no recourse. “It’s been known for a long time that no bank can afford to challenge a regulator or an enforcement authority,” says one bank lawyer. “As part of that I think there’s been discretion by the enforcement authorities or the regulators not to overplay their hand or impose penalties unless they could really be justified. I don’t think the discretion is being used.”

This opinion might not elicit much sympathy outside Wall Street but it is widely shared among the banks and their counsel, some of whom put the change of stance in more dramatic terms of extortion or worse. “It’s hostage taking,” says one. “It’s regulators acting lawlessly.”