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Pest Control: Why the Feds Won't Stamp Out CDO Termites

The SEC's lawsuit against Goldman Sachs (GS) raises a key question: Is the case aimed at a single investment bank, a handful of institutions or all of Wall Street?

The answer will shape how the litigation unfolds and what, if anything, happens after it ends. For now, it appears that securities regulators are casting a wide net, with reports that the agency is looking into other collateralized debt obligation deals between banks and hedge funds.

Yet it's unclear if the Obama administration has the political will to pursue multiple investigations, should the SEC churn up much dirt. That, in turn, relates to another calculation -- how the Goldman case and any other federal action related to the housing bust affects the debate in Washington over financial reform.

Writes noted investor and market analyst John Bougarel:

If the government intent is simply to save face and improve its sorely lacking credibility with the public, this case will be limited to a few firms and a few individuals, and the rest of the world will go about their lives knowing nothing substantial has been done to insure the public against socializing future losses of these predatory institutions.... If, however, the government were to acknowledge this looting has been a direct result of the failure of the whole system, then real change will occur.
My bet's on the first option. For all the tough talk coming out of the White House in recent months, it has to date studiously withheld support for the strongest banking reform measures, such as outright bans on certain types of derivatives, hard caps on bank size and a tax on securities trading. That moderation is reflected in the relatively soft bills in Congress.

Much as in the health care fight, from the outset the Democrats have favored what they evidently regard as more politically viable financial reforms over a full-fledged overhaul. That appears to reflect Obama's preference for piecemeal change. It's also a matter of timing. As the November election approaches, lawmakers will beat up on banks; above all, however, they -- and Obama -- want an actual law to show off before constituents go off to vote. That, too, puts a premium on moderation (or capitulation, depending on your perspective).

Against this background, in the short-term I don't see the SEC waging jihad on Wall Street as part of an all-out campaign to purge it of the conflicts of interest that underlie the Goldman case. For one thing, those conflicts infest financial services like termites at a carpentry convention. Stamping them out, if that's even possible, would require the government to completely revamp the OTC derivatives market and strictly regulate the relationships between big investment banks and hedge funds.

Nothing suggests the government has the appetite for that sort of undertaking.

In some ways, it doesn't matter that much. As economist Dean Baker notes, in terms of preventing future financial crisis the Goldman suit is a sideshow. CDOs worsened, but didn't cause, the meltdown. What did? A lending-fueled housing bubble. Smoking out a verminous institution like Goldman may be satisfying -- and just. But it probably won't do much to protect us from whatever speculative beasties are scuttling around in the basement.

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