How the Goldman Sachs Suit Will Affect Financial Reform

Last Updated Apr 21, 2010 11:16 AM EDT

As the big investment banks like Goldman Sachs and Morgan Stanley report billion-dollar profits and the SEC pursues a suit against Goldman for allegedly selling securities that were designed to fail , what are the implications for financial reforms that are now on the table? And what does the state of the financial industry now reveal about the health of the U.S. economy? Diane Swonk fills us in. -Nelson Wang
Big Banks vs. Community Banks
Even though many big banks are reporting strong profits, the unspoken side of the story is what's going on at a community bank level, where losses are mounting. Many of the large banks now have written off losses related to the subprime debacle, and are in a position to make a lot of money now. But the smaller community banks are just getting hit with losses related to high unemployment and to the commercial real estate market. Community bank portfolios have between 40 and 60 percent of their portfolio exposed to commercial real estate, while the very large commercial banks have only 12 to 15 percent, and the number's even lower for investment banks like Goldman Sachs. So community banks are facing mounting losses, both because their customers are defaulting after a long recession, and the commercial real estate sector is the next leg down.

No Boon Yet for Consumer Credit
The healing that we've seen in the large banks has yet to provide much credit to consumers. The credit situation for consumers and small businesses is very tight and community banks tend to be the backbone of credit to small businesses. So even as the large banks make big bucks, we're not seeing the credit problems for consumers and small businesses easing up much. We're still sort of waiting for the strong performance of Wall Street to filter down to Main Street, and the reason it's not is because the overwhelming number of community banks that are struggling now.

'People Want to See Blood on Wall Street'
The implications of SEC suit against Goldman for financial reform are very unclear. What's really important, though, is that the financial services industry needs to know where reform is going so they can get back in the game of placing bets. My guess is, the Goldman issue has definitely heated up the situation for getting regulatory reform done, but it's really unclear which way the winds are blowing.

Although there are fewer banks left on Wall Street, and the world did change as a result of the crisis, the big banks are operating as if it's business as usual. And for the rest of the country, there's nothing usual about business. And I think that's one of the issues why we're seeing things like this with Goldman -- whether the accusations are founded or unfounded, the fact is that people feel a need to see blood on Wall Street. There's been a lot of blood already spilled, but when banks are making record profits and giving out record bonuses again, there's a lack of justice that's being felt by Main Street.

The reality is that whether Goldman was in trouble during the financial crisis or not, it would have gone down with the rest of the financial services industry if the government hadn't stepped in. And it's a little disingenuous for Goldman to say 'we're so smart, we make money' without acknowledging they wouldn't have had a chance, either, if the whole system went down. And that lack of humility on Wall Street has prompted some of this backlash, which could result in unnecessary reforms and regulation and be detrimental. Everyone wants to play the blame game, but the reality is we're all in this together, and until we all figure that out, we're not going to get the right solutions.

Financial Reform Can Still Get Done
I still have a lot of faith that financial reform can get done, although that faith can be fleeting. I think the people who really want to get it done and to get it done right -- people like Corker, Dodd, Geithner, and Ben Bernanke -- are ultimately working on the same page. The problem is of course, the noise; this cannot be another health care reform debate. But I've been very encouraged how much specific people have been willing to make this a bipartisan bill. And I think we need that right now.

What's Missing from Proposed Regulation
What's stunning about this legislation is there's nothing about how we go about underwriting mortgages in this country and monitoring that. One of the main concerns of the Fed has been and continues to be the lack of underwriting that occurred on the subprime mortgages, beyond the financial instruments like CDOs that allowed the situation to escalate. We're talking about "ninja loans" -- no income, no job, applications. The way that many of these mortgage companies and non-bank shadow institutions did business in many of these cases was unethical and fraudulent. The reality is going forward, there's not a lot to prevent them from doing it again.

And that's something the Fed is concerned about because if they have to be responsible to clean up the mess of people they didn't regulate, then they want to regulate them. Those issues really haven't been dealt with yet. So it's a first step, but there's still a lot of things that are missing in the proposed reforms.

Diane Swonk, chief economist at Mesirow Financial, talks to CBS MoneyWatch twice a week about the day's top economic news and developments. Her responses are edited for clarity and length.