While the Securities and Exchange Commission’s (SEC) allegations that Goldman Sachs defrauded clients is big news, the case also raises a broader issue that goes to the heart of how Wall Street has strayed from its intended mission.

Wall Street’s purpose is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades, like billions of dollars of similar trades sponsored by almost every Wall Street firm, raised nothing for nobody. In essence, they were simply a side bet that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of SEC’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced" such bonds. Thus the investors weren’t truly “investing"— they were gambling on the success or failure of the bonds that actually did own mortgages.

The SEC suit charges that the bonds referenced in the Abacus deal were hand-picked (by hedge fund manager John Paulson) to fail. Goldman says Abacus merely allowed Paulson to bet one way and investors to bet the other. But either way, is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks such as Goldman?

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were a reason the housing bust turned out to be more destructive than anyone predicted.

In a free-market economy, we want people making considered calculations of risk. But buyers and sellers of credit default swaps often have no stake in the underlying instrument. Allowing speculators to bet on entities in which they have no stake is similar to letting your neighbour take out an insurance policy on your life.

And even when these instruments are used by banks to hedge against potential defaults, they raise a moral hazard. Banks are less likely to scrutinize mortgages and other loans they make if they know they can reduce risk using swaps. Irrespective of who is holding the hot potato when the music stops, the net result is a society with more risk overall.

As it considers its financial reform options, the US Congress’ first priority should be to end the culture that “financializes" every economic outcome, that turns every mortgage or bond issue into a lottery—often with second- and third-order securities that amount to wagers on wagers of numbing complexity.

First, it should insist that all derivatives trade on exchanges and in standard contracts—not in customized, build-to-suit arrangements such as the ones Goldman created. Wall Street might have legal grounds to fight this—a derivative is a contract between private parties. But the financial bailout has demonstrated that big Wall Street banks fall firmly within Washington’s regulatory authority, and regulation confers implicit bailout protection.

Second, Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy or sell credit default swaps. If it doesn’t ban the practice, it should at least mandate that regulators set stiff capital requirements on swaps for such parties. Also, tax policy could be changed to skew heavily against swaps contracts that are held for short-term periods.

The government would not look fondly on Caesar’s Palace if it opened a table for wagering on corporate failure. It should not give greater encouragement for Goldman Sachs to do so.


Edited excerpts. Roger Lowenstein is a contributing NYT Magazine writer and the author of The End of Wall Street (2010). Comment at otherviews@livemint.com