WHY have so few gone to jail for the financial crisis? The boom and bust in S&L lending in the 1980s ended with nearly one thousand people sent to jail for financial fraud—and that experience was quite mild compared to the recent cycle. A few days ago, America’s public television channel ran a special documentary programme about this curious phenomenon called “The Untouchables.” (You can watch the whole thing here*) The government’s prosecutors argued that it is very difficult to prove fraudulent intent beyond a reasonable doubt. They said that it is more rewarding from the perspective of the public interest to reach negotiated settlements rather than go to trial and lose. After all, America’s Justice Department failed to convict two Bear Stearns hedge fund managers of lying to investors about their exposure to subprime losses, despite initial expectations that the case would be easy. The Securities and Exchange Commission, which had opened a civil lawsuit against the duo, decided to avoid a trial and settled with the accused on terms dismissed by the presiding judge as “chump change.” Most subsequent civil suits launched by the SEC have been targeted at firms rather than individuals, which means that shareholders were the ones who had to pay, rather than anyone who may have been directly responsible. This track record has led others, including several featured in the programme, to wonder whether prosecutors have been sufficiently vigorous and whether they have the right priorities.

Part of the problem may have been the failure of prosecutors to target the right people for the right things. Remember what Thucydides, the ancient Greek historian, said about the Athenian empire:

The Athenians were very severe and exacting, and made themselves offensive by applying the screw of necessity to men who were not used to and in fact not disposed for any continuous labour...For this the allies had themselves to blame; the wish to get off service making most of them arrange to pay their share of the expense in money instead of in ships, and so to avoid having to leave their homes. Thus while Athens was increasing her navy with the funds which they contributed, a revolt always found them without resources or experience for war.

From this perspective, the real wrongdoers were not those who sold risky products at inflated prices but the dupes who bought them on behalf of so many savers and pensioners. (This is not a legal judgment. I am not a lawyer. But I did study ancient history.) One explanation for the confusion is that many things that are considered normal in finance look like fraud to almost everyone else. This does not mean that nothing illegal occurred, but it does help explain why many actions that appear so distasteful have not been prosecuted in the courts. If more people become familiar with this foreign mentality, they might be much less likely to fall for some of the schemes that have caused so much pain over the past few years. At the very least, they will be less likely to tolerate investment managers who lose them money because they are so easily hoodwinked.

Consider the latest investigative piece by Jesse Eisinger of ProPublica, which paints an unflattering portrait of Morgan Stanley’s internal deliberations:

On March 16, 2007, Morgan Stanley employees working on one of the toxic assets that helped blow up the world economy discussed what to name it. Among the team members’ suggestions: “Subprime Meltdown,” “Hitman,” “Nuclear Holocaust,” “Mike Tyson’s Punchout,” and the simple-yet-direct: “Shitbag.” Ha ha. Those hilarious investment bankers. Then they gave it its real name and sold it to a Chinese bank.

Matt Levine, of Dealbreaker (and a former Goldman banker), replied that the emails actually tell us very little:

One thing that would probably be fun would be reading the internal emails sent around at the places that bought terrible RMBS CDOs in the end times of 2006-2007. What did they say? Was it “these mortgages are worth twice what Morgan Stanley is selling them for! We are ripping their faces off”? Was it “I looked through a representative sample of the mortgages underlying the collateral in this deal and I think the yield more than justifies the risks”? Was it “my asset-level diligence was light because my macro view is that house prices will go up a lot in the next 18-24 months”? Was it “we have to invest $100mm somewhere and this gets 2bps more yield than other AAA-rated options”? Was it “I don’t know that much about mortgages but I sure am glad we can trust our friends at Morgan Stanley to put us in such a high quality product as this here CDO”? The possibilities are endless and, I think, fascinating: each trade has two sides, and each side has a view, even if that view is sometimes more of a vacant stare.

To most people, it is immoral if not illegal to sell things that you believe to be defective. Drug manufacturers and carmakers are not treated kindly by the justice system when they knowingly release products that have a tendency to maim and kill their customers. Surely the same standards ought to apply to the manufacturers of financial products that fail to compensate investors for the risk of loss.** People with this perspective conclude that the absence of prosecutions is a sign of incompetence, corruption, or both.

But to those with a background working in the industry (including your correspondent), many financial transactions are nothing more than zero-sum bets. Whoever wins does so at the other’s expense.*** By definition, anyone who is selling financial assets has the option of not selling them (assuming he is not desperate for cash). Think about the implications of that. A firm decides to go public and sells shares. Translation: the existing owners want to cash out and the bank approached to underwrite the sale is not interested in buying the stake for itself. A broker-dealer sales desk calls you with trade ideas. Translation: the firm’s prop desk wants to close out a position at your expense. A bank offers to bundle some loans on its books, break up the cash flows into tranches, and sell them to you as securities. Translation: the bank is trying to dump its garbage on you.

It is worth stressing that none of these actions could reasonably be called criminal, or even immoral, when everyone involved understands what is going on and has accurate information. The issue is if your counterparties are lying to you, just like when a used car dealer knowingly sells a lemon without disclosing the relevant facts. (There are lots of civil suits right now between bond insurers and banks about this very issue.) However, assuming you all know just as much, there is no reason to think that one party has an edge even if their internal deliberations suggest otherwise. That is the point Mr Levine was making. AIG sold so many credit default swaps because they thought risk was overpriced and they wanted to take advantage of it. If they had been right, everyone who got rich by buying protection, like John Paulson, would instead have looked like chumps. Some people cash out of businesses that they started because they sense that the peak has arrived, as was probably the case with Groupon and Blackstone. (Anyone who thinks that a private equity firm would sell itself at a discount should not pick stocks. Or do anything involving money, actually.) But some people cash out way too early.

No one has any business running money if they do not understand that this is how the game works. For me, the key question is why so many evidently unsophisticated investors were snookered by the banks into buying their garbage. As the saying goes, you cannot con an honest man. Investors were not forced to take the losing side of so many trades. The appeal of the senior tranches of the subprime CDOs was that they claimed to be almost riskless compared to USTs but paid more. Anyone who had stopped to think critically should have been very suspicious. But they were making too much money to be bothered. The victims in this case were the retirees and savers who were depending on their institutional money managers to make good decisions on their behalf. For all their other misdeeds, the banks would not have kept producing garbage loans had they not been able to sell them to willing buyers. Some of those buyers must have violated their fiduciary responsibilities by, at the very least, failing to do due diligence. Perhaps prosecutors should invest some of their energy there.

It is worth pointing out that Fannie Mae and Freddie Mac, America’s government-sponsored enterprises, were buying more than one-third of the toxic “private-label” mortgage securities issued in the mid-2000s. This was not because of any law requiring the agencies lend to the poor or to minorities, but because it was insanely profitable for them. Their executives earned fortunes during the good years as they arbitraged the difference between their funding costs and the yield on subprime CDOs with 50:1 leverage. When it blew up in their faces, taxpayers had to foot the bill. It seems like an under-explored area for prosecutors to investigate.

Of course, we will never be finished assigning responsibility for the boom and bust until we figure out why so many investors were so desperate to get those few extra basis points of yield in the first place.

*One of the most interesting moments was when Lanny Breuer, the head of the Criminal Division of America’s Justice Department, said he did not believe in prosecuting any firm if he thought that doing so might endanger the stability of the financial system. It may not appear unreasonable at first glance, but taken seriously, this legal theory seems to encourage banks and other intermediaries to become “too big to jail.” Once large enough, they could effectively get away with money laundering, tax evasion, bid-rigging, bribery, and accounting fraud. On Wednesday, the Washington Postreported that Mr Breuer will soon be leaving his job.

**One big difference is that drugmakers and carmakers can actually know whether their products are harmful because they have the ability to test them before releasing them to the public. Financiers cannot say with certainty that a given product will have a negative expected return.

***Obviously there are plenty of things that go on in finance that are not zero-sum. Underwriters are paid a percentage of the funds they raise for clients, which is supposed to align their interests. If bond or share prices rise after being issued, that represents a missed opportunity for both parties rather than a transfer between them. Broker-dealers can earn money simply by collecting the spread between bids and offers, although it is very hard to disentangle those sorts of trading profits from proprietary decisions when looking at income statements. Properly-constructed swaps can help institutions hedge their liabilities even as they generate profits for dealer banks. Good lawyers are needed to protect everyone’s interests. And, of course, skilled money managers are worth their high fees if they can consistently provide uncorrelated alpha to their investors, although these excess returns generally come at the expense of someone else.