Who Crossed the Line on the Street?

The hunt for lawbreakers tied to toxic mortgages is under way

By Mara Der Hovanesian

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Bear Stearns' Cioffi, arrested in June, is out on bail Daniel Acker/Bloomberg News

Federal and state investigators, eager to show the world that they're on the case, are sifting through Wall Street's debris looking for evidence of wrongdoing. What they know is that big banks created toxic mortgages and securities that brought the global financial system to its knees. What they're trying to figure out is whether firms broke the law, too.

Judging from the growing chorus of angry taxpayers and investors, there will be a push to pin the blame on CEOs, directors, and others at the highest levels of finance. Federal securities regulators, U.S. attorneys, and state attorneys general are investigating a range of possible misdeeds, including the misleading of shareholders, the approval of fraudulent loans, and the foisting of inappropriate mortgages on borrowers. "People want the most visible faces of these companies to pay," says Pravin B. Rao, a former SEC official and currently a partner with corporate law firm Perkins Coie.

So far there has been only one high-profile criminal case: the June arrests of former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin for alleged fraud. (Both pleaded not guilty.) More arrests are likely. "We will probably have more cases as information about criminal activity comes in," says Bill Carter, a spokesman for the FBI.

PAPER CHASE

Investigators are especially focused on so-called exception loans, mortgages that didn't meet the income and other financial guidelines set by Wall Street. Prosecutors are trying to figure out if banks knowingly pushed bad loans through the system. Earlier this year, New York Attorney General Andrew M. Cuomo subpoenaed Clayton Holdings (CLAY), a firm hired by Wall Street to ferret out problem loans before they went into mortgage pools. Former Clayton CEO Frank P. Filipps says the firm regularly found mortgages that didn't fit all the criteria, but that banks ultimately decided whether to pull the loans.

As part of their hunt, investigators are looking for hard evidence of activities of the sort that former Countrywide wholesaler John Sipes claims occurred routinely. He says underwriters at the Santa Monica (Calif.) and Beverly Hills branches of Countrywide often shredded tax documents they received from borrowers to destroy proof of the borrowers' incomes and extend bigger loans than they could afford.

The practice was so rampant in those two branches that the corporate offices launched an internal probe. Each night, Sipes says, Countrywide investigators collected the bins from paper shredders and analyzed their contents. After a while, he says, the branch managers told them: "Don't put anything in the shredder bins at work. If you're going to shred, take it home." Says Dan Frahm, a spokesman for Bank of America (BAC), which acquired Countrywide in July: "Bank of America management has led a detailed review of Countrywide operations and is now hard at work building a combined organization that will be recognized as a leader in responsible lending practices."

What prosecutors most want is a smoking gun—an e-mail or other document that proves someone intentionally crossed the line. Looking for such clues, the FBI has seized the hard drives of executives at several big banks in recent months. Says Ellen Zimiles, a former assistant U.S. Attorney and co-founder of the fraud risk management firm Daylight Forensic & Advisory: "There will be a paper or electronic trail out there."

Der Hovanesian is Banking editor for BusinessWeek in New York.