Yesterday, U.S. prosecutors in Brooklyn lost their criminal case against two former managers of Bear Stearns’s internal hedge funds. But the acquittals aren’t a setback for financial markets’ health; they’re a step forward. They show that the public understands that Washington can’t fix our fragile financial markets through criminal cases. It must do so through regulatory change instead.

The case was the first important criminal trial to emerge from the global financial crisis. The feds accused the two defendants, Ralph Cioffi and Matthew Tannin, of committing criminal fraud and conspiracy in 2007. According to the charges, Cioffi and Tannin talked up their mortgage-related funds to investors while freaking out about them in private. For example, in spring 2007, according to the Wall Street Journal, Cioffi fretted to his colleague that he saw “simply no way for us to make money—ever,” even as he assuaged investors’ fears. But the government’s argument didn’t fly. After the verdict, one juror even offered explicit support for the defendants, telling the New York Post that the two men had tried to save their clients’ money, not lose it. “If this was really a fraud case, they wouldn’t have worked that hard” at trying to rescue the investments, said Aram Hong, adding that she would even invest her own money with them.

Why the sympathy for rich men in suits? Just a few years ago, jurors were happy to send former Enron CEO Jeff Skilling to the clink, possibly for the rest of his life (though the Supreme Court is hearing his appeal). The charges against Skilling weren’t so different from the charges here: he had committed crimes, the government argued, partly by putting on a brave face to the public while trying futilely to deal with sudden, massive losses on impossibly complex investments. Prosecutors must have thought that jurors would be even more willing to convict now, during the worst financial and economic crisis since the Great Depression.

Instead, the jurors rebelled—and if prosecutors had looked back to history, they wouldn’t have been surprised. Nearly eight decades ago, Samuel Insull, a Chicago utility titan, became a public face for the excesses of the twenties. As John F. Wasik has chronicled, Insull used cheap, easy money to create an impossible tower of debt securities on top of stock securities and stock securities on top of debt securities, all based on the premise of ever-mounting profits. When profits stopped rising, the tower fell and investors lost everything.

Prosecutors tried Insull three separate times and lost each case. Why? The juries decided that Insull’s failure constituted not a crime but evidence of the systemic failure of financial capitalism to regulate itself. Putting Insull behind bars wouldn’t solve anything; he had acted rationally in an irrational world. He could borrow to the extent that he did before the Depression, for example, because regulations to rein in speculative borrowing were nearly nonexistent. He could do so largely without investors knowing about the risks that he was taking because requirements to disclose such things consistently and publicly were also nonexistent.

The prosecutors’ defeat back then didn’t prove damaging to markets or to the economy. Even as prosecutors tried Insull, policymakers in Washington understood the real task: to protect the economy from the unrestrained excesses of financial markets, largely through civil, not criminal, solutions. Regulators put in place simple, uniform rules to limit speculative borrowing, so that, for example, nobody could borrow more than half of the purchase price of a stock. Regulators also required fair public disclosure of corporate risk, as well as consistent public reporting of financial markets’ activities.

This system worked well until the eighties, when financial firms and markets began to find ways around these reasonable regulations. Financial instruments like mortgage-backed securities escaped limits on borrowing, while credit-default swaps escaped limits on borrowing and disclosure. The financial world could once again get away with what Insull and others had done in the twenties: building intricate towers of limitless debt, destined to fall. The broader economy, too, became dependent on this ever-increasing debt.

But over the past two decades, Washington persistently failed to see that a financial system that escaped its limits on debt and on disclosure was growing untenable. Instead, the government saw scandals from Michael Milken to Enron not as evidence of civil regulatory breakdown but as unique criminal cases. The public went along, distracted from the real problem by high-profile villains. Consider what the Times said after Skilling’s 2006 conviction: “We hope the jury’s verdict deters other corporate kingpins from breaking the rules.”

Today, though, the public seems to understand that regulation through prosecution won’t work. In the Bear Stearns case, the jury recognized what the Insull jury saw long ago. Cioffi and Tannin weren’t criminals, but imperfect people doing their best in a world with no reasonable constraint. When the entire financial system fails, that failure isn’t any one person’s fault. It means that there’s something wrong with the system, something that can’t be locked away in a cell.


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