By Andrew Grossman, Emily Glazer and Christina Rexrode
Assistant U.S. Attorney Richard Elias was leafing through a pile
of J.P. Morgan Chase & Co. documents while tending to his
newborn son in 2012 when he found something that came back to haunt
the three largest U.S. banks.
In a memo, one J.P. Morgan employee warned her bosses they were
putting bad loans into securities being created before the
financial crisis hit.
The U.S. attorney's office in Sacramento, Calif., soon started
sending subpoenas to J.P. Morgan officials tied to the memo. Three
months later, top Justice Department officials in Washington told
investigative teams across the country to hunt for similar
ammunition in tens of millions of documents from other banks,
especially Bank of America Corp. and Citigroup Inc.
In a move meant to shake money from the banks, the Justice
Department decided to go after them with an unusually potent law
created to clean up the savings-and-loan crisis of the 1980s. The
law has a lower burden of proof than other laws used by the agency
to punish alleged fraud, a much longer statute of limitations and
potentially astronomical financial penalties.
Mr. Elias's discovery has delivered a whopping payoff so far:
$36.65 billion, representing the cost of the government's three
separate settlements with the banks since late 2013, including the
$16.65 billion deal with Bank of America in August that is the
largest ever between the U.S. and a single company.
The total is by far the biggest single chunk of an estimated
$128 billion in crisis- and mortgage-related settlements, fines and
other costs incurred by the six largest U.S. bank holding
companies, according to SNL Financial. Ongoing investigations could
push the tally higher.
"Given the magnitude of the conduct, I believe the settlement
was fair and just," says Mr. Elias, 39 years old, who got the
Justice Department's second-highest employee-performance award for
his work on the J.P. Morgan case.
Like so much else about the 2008 financial crisis, though, the
final reckoning is more complicated. Privately, executives at Bank
of America, Citigroup and J.P. Morgan are seething. They say
numbers used by the government as a prod to settle were arbitrarily
huge, and the banks claim the Justice Department's maneuvering with
the S&L-era law was used to bully them.
Government officials say they wanted to punish the banks but not
cripple them financially.
Bad blood runs especially deep at Bank of America and J.P.
Morgan. They acquired Merrill Lynch & Co., Countrywide
Financial Corp., Bear Stearns Cos. and most of Washington Mutual
Inc. with government encouragement as it scrambled to contain the
crisis. Most of the securities attacked by the government were
created before those takeovers.
One of the country's best-known banking lawyers, H. Rodgin
Cohen, senior chairman of law firm Sullivan & Cromwell LLP,
says the three gigantic settlements have deepened the distrust
between bankers and regulators as the crisis recedes. As a result,
"ultimately, the banks are reluctant to be innovative and make
loans," Mr. Cohen says.
Critics counter that the government let the banks pay too small
a price for sloppy and fraudulent loans, the pell-mell assembly
line of mortgage securities that disintegrated into staggering
losses for investors, and other negative consequences that spread
throughout the world.
The $36.65 billion which Bank of America, Citigroup and J.P.
Morgan agreed to pay the Justice Department, seven states and other
government agencies or as aid to borrowers is roughly equal to the
U.S. banking industry's third-quarter profit.
A spokesman for the Justice Department said it has "taken
historic actions to hold banks accountable for pervasive schemes to
defraud investors in residential mortgage-backed securities." The
agency "will continue to devote energy and resources to these
investigations," he added.
This description of the Bank of America, Citigroup and J.P.
Morgan investigations and settlements is based on interviews with
people on both sides.
Things weren't going well for the Justice Department before Mr.
Elias found the J.P. Morgan memo. In January 2012, President Barack
Obama announced in his State of the Union address that a new group
of federal lawyers and state attorneys general would expand
government probes of "abusive lending and packaging of risky
mortgages that led to the housing crisis."
The group got off to a slow start. Investigations were
distributed to U.S. attorney's offices across the country, but
federal officials could find little evidence needed to win a big
civil or criminal case alleging fraud.
Near the end of conference calls, Mr. Elias, who became a
federal prosecutor in 2011 and worked in a satellite office in
Fresno, Calif., said the U.S. attorney in Sacramento didn't have a
case but wanted one. In October 2012, Justice Department officials
in Washington asked his boss, Benjamin Wagner, to start digging
into J.P. Morgan.
As soon as he saw the memo, Mr. Elias believed the government
had a case against the bank. Summoned to Justice Department
headquarters in January 2013 for a meeting scheduled to last 45
minutes, Mr. Elias and two colleagues were peppered with questions
for twice as long.
The agency's No. 3 official, Tony West, turned to a deputy and
said: "This case has to be our model. We need to be doing this with
the other districts."
Justice Department officials set a deadline: They wanted a big
win by the end of 2013. Attorney General Eric Holder, who had begun
making plans to step down, felt heat from Democratic lawmakers
impatient about the lack of crisis-related charges against a big
bank or top executive.
Investigators across the U.S. were told to scour other banks'
internal documents for similar incriminating evidence. Lawyers
searched company records for some of the same words Mr. Elias saw
in J.P. Morgan documents, such as "fallout" and "kick" as nods to
the percentage of bad mortgages in a certain pool.
Lawyers soon found suspicious documents at Citigroup and
Merrill. For example, due-diligence companies hired by the firms
had assigned "event grades"--one was the best, and three was the
worst--to loans to signify whether they met the firm's own
underwriting standards.
Investigators concluded that some loans with the lowest event
grade wound up in mortgage securities pitched to investors with
prospectuses that promised higher-quality loans overall.
"These are the worst mortgages I've ever seen," a J.P. Morgan
banker emailed about a deal.
In a 2007 email, a Bank of America trader complained about
efforts to add low-quality loans to one deal. Traders faced risk if
problems erupted with the underlying loans. "Like a fat kid in
dodgeball, these need to stay on the sidelines," the trader
wrote.
The J.P. Morgan memo also breathed life into an idea Mr. West
mentioned to U.S. attorneys after taking over the Justice
Department's civil division in 2009. The Financial Institutions
Reform, Recovery and Enforcement Act of 1989 includes a provision
for civil penalties for fraudulent conduct "affecting a federally
insured financial institution."
Lawmakers wrote the provision to go after fraud in which a bank
was the victim, and it was rarely used after the S&L mess's
cleanup. As government lawyers became convinced that banks
knowingly sold flawed mortgage securities, the agency decided to
aim Firrea directly at the banks.
The government jolted the banks with a February 2013 civil
lawsuit against bond-rating firm Standard & Poor's Ratings
Services, seeking $5 billion under Firrea's civil-penalty
provision. The suit was filled with internal emails that the
government cited as evidence S&P defrauded investors by
assigning good ratings to mortgage-backed securities it knew were
bad.
S&P, a unit of McGraw Hill Financial Inc., has vehemently
denied the allegations but has been open to a possible
settlement.
Mr. West asked one of the lead lawyers in the S&P lawsuit,
Geoffrey Graber, to use Firrea to help accelerate the mortgage-bond
investigations. Some investigators were making progress, while
others seemed stuck in "rabbit holes," one federal official
recalls.
Bank lawyers said the S&P suit was a warning to banks that
the Justice Department could come after them with Firrea. The law
has a 10-year statute of limitations, compared with three to five
years in most civil cases. It is a powerful alternative to criminal
prosecutions because the government must prove the defendant's
guilt only by a "preponderance of the evidence," rather than
"beyond a reasonable doubt."
Government lawyers were emboldened by a federal court judge's
refusal in April 2013 to throw out a non-crisis-related civil suit
in which the Justice Department wielded Firrea against Bank of New
York Mellon Corp. The bank was accused of cheating customers on
foreign-exchange transactions.
The bank's lawyers claimed Firrea wasn't meant to target banks
as the alleged perpetrator. The judge disagreed but hasn't ruled on
the overall case.
In response to sprawling subpoenas, banks responded with dozens
of terabytes of data. "It was almost like decoding the DNA of the
individual bonds by tracing it back over the generations of due
diligence to the original pools," says John Walsh, the U.S.
attorney in Colorado and co-head of the group announced by
President Obama in 2012.
By mid-2013, Mr. Elias and other lawyers were nearly done
drafting a lawsuit alleging that J.P. Morgan misled investors about
the quality of mortgages packaged into bonds. Other U.S. attorneys'
offices were deploying more employees to sort through bank
data.
J.P. Morgan executives were eager to settle. Bank lawyers hired
mock juries to gauge how their side of the case might play out in a
courtroom. The results were disheartening, especially when the
"jurors" saw internal emails. J.P. Morgan offered $1 billion to
settle some allegations.
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The offer brought a curt reply from Justice Department lawyers,
who said J.P. Morgan ought to be thinking about a number closer to
$20 billion. The agency's lawyers believed they could win cases
alleging that Bank of America, Citigroup and J.P. Morgan were each
responsible for at least tens of billions of dollars in investor
losses on mortgage deals.
During negotiations, the government's numbers shrank when
considering factors often weighed in civil cases, such as potential
deterrent value, the defendant's ability to pay and case law, which
was relatively sparse.
The banks got few answers when lawyers "asked where the numbers
came from," says a person close to the banks. "We were told they
came from the attorney general of the United States."
In a follow-up meeting with J.P. Morgan, federal officials told
the bank it was being offered a good deal. Executives were shaken
by the possibility of huge financial damages and feared potential
restrictions on acquisitions, bank-branch expansion and new-product
development.
Still, the two sides were far apart during September 2013
settlement talks in Mr. Holder's conference room. In addition to
the settlement amount, lawyers sparred over whether the deal would
end an ongoing criminal investigation into misleading investors.
That probe is continuing.
Deputy Attorney General James Cole, the No. 2 official at the
Justice Department, interrupted the squabble, told J.P. Morgan
executives and lawyers that it could end the criminal probe by
pleading guilty, stood up and left for another meeting. But the
bank and government still couldn't reach a deal.
Later that month, the Justice Department was hours away from
plowing ahead with a civil suit against J.P. Morgan when Chairman
and Chief Executive James Dimon called Mr. West on his cellphone to
say the bank could increase its offer.
About eight weeks later, the government announced a $13 billion
settlement with J.P. Morgan. The bank neither admitted nor denied
wrongdoing, but it agreed to a "statement of facts" that included
damning details.
Negotiations with Citigroup and Bank of America had a similar
tone. " 'We don't care' was the response to every substantive
argument the banks made," says a person close to the banks. Justice
Department officials say they weighed the counterarguments and
adjusted some demands.
In May, Citigroup was told the government wanted roughly $12
billion. The bank dug in its heels at $7 billion, and the
government eventually agreed. The deal was announced in July.
Bank of America executives were aghast at the government's
demand for $20 billion. Chief Executive Brian Moynihan later asked
to speak to Mr. Holder. Federal officials said no.
A crucial turning point came when a federal judge ordered the
bank in July to pay $1.27 billion tied to a Countrywide loan
program known as "Hustle." The government had invoked Firrea in the
civil case.
Mr. Moynihan got more bad news when Mr. Holder called the same
day to say a U.S. attorney was ready to file a civil suit over
Merrill bond deals. The settlement was announced three weeks later.
Bank of America says it will appeal the judge's Hustle ruling.
Write to Andrew Grossman at andrew.grossman@wsj.com, Emily
Glazer at emily.glazer@wsj.com and Christina Rexrode at
christina.rexrode@wsj.com
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