Systemic flaws

NEW YORK-As thousands of union workers gathered to march on Wall Street, the video screen over their heads showed a preacher in a clerical collar raising his hands as a piano beat a cadence in the background. He yelled, "Are you tired of the banks? Hallelujah!" A loudspeaker blared the Chi-Lites singing, "For God's sake / Why don't you give more power to the people?"

Later Rabbi Ellen Lippmann, founder of Voices of Our Lives, took the podium at the April 29 event, quoting an ancient Jewish proverb about God rotating the universe so that the star of the rich and unjust falls to the bottom, and the star of the poor and disenfranchised rises to the top: "Soon God will rotate the universe in such a way that the star that's on top will sink to the bottom."

That sinking appeared to be happening down in Washington, D.C. As the Senate debated financial regulations and the Senate Permanent Subcommittee on Investigations grilled Goldman Sachs executives on their financial practices, two threads of debate emerged. One was practical: How can we prevent another economic disaster? The second was moral: Are the banks not just financially but morally bankrupt?

The Securities and Exchange Commission (SEC) has charged Goldman Sachs with securities fraud. The accusations come down to this: A hedge fund named Paulson and Co. was betting against a financial package called a collateralized debt obligation (CDO), and Goldman Sachs allowed Paulson to help pick the content of the package it was betting against without telling the clients who were investing in the CDO and betting on its success. Goldman brokers were selling products they knew were doomed to fail, says the SEC, and they were themselves betting that the products would fail.

Ethically shady? Publicly, Goldman Sachs says no, although personal emails tell a little different story. Fabrice Tourre, who is charged in the SEC complaint since he was personally responsible for the CDO, wrote emails that show he was morally conflicted about selling something doomed to fail. But he also seemed to boast to his girlfriend that he was able to sell bad bonds "to [a] widow and orphans."

When the Senate Permanent Subcommittee on Investigations grilled Tourre and other Goldman Sachs executives, senators repeatedly pressed the executives to admit ethical wrongdoing. The executives balked. They slowly flipped through big binders of documents and gave long, halting answers as senators complained that the executives were stalling.

Sen. Carl Levin, D-Mich., asked, "How do you view your ethical responsibilities?" before moving on in frustration, saying the executives refused to answer the question. Daniel Sparks, former head of the mortgage department, later told the senators, "I don't think that Goldman did something wrong. . . . Wrong, to me, has some qualitative comment about doing something inappropriate. That doesn't mean we didn't make mistakes and do deals that didn't turn out the way they were supposed to."

Meanwhile, debate has gone ahead about financial regulation that does not-and cannot-address all these ethical questions directly, but could clear up the ethical muddle by creating market transparency.

Various regulation proposals include allowing shareholders to limit executive pay; reducing the size of banks by requiring them to keep more capital to offset their risks; keeping a pot of money, made up of contributions from the financial industry, that would help those banks that are "too big to fail" to liquidate; establishing a council to scrutinize financial companies whose downfall would endanger the country's financial stability; and regulating derivatives, or contracts like the kind Goldman conducted, which involve placing bets on the future price of an underlying asset.

Nicole Gelinas, senior fellow at the Manhattan Institute and author of After the Fall: Saving Capitalism from Wall Street-and Washington, argues that it is better to start small, by regulating derivatives and trading them on a public exchange, along with putting stricter limits on what banks can borrow. This, she says, would do more toward stopping the next "too big to fail" bailout than creating a council to try to predict the future and regulate systemic risk. Such a council, in this view, would hamper market discipline by steering investors toward particular banks with an implicit seal of governmental approval.

Gelinas said if derivatives are sold on the public exchange, they will become simpler and thus more transparent, creating less opportunity for misdealings. If Goldman Sachs or other firms parsed words and made excuses for dubious ethics, they would lose client confidence and their own business would suffer, she said: "They need the rest of the world to think they are being ethical and honest with their clients."

Tunku Varadarajan, a fellow at the Hoover Institution and professor at New York University's Stern School of Business, agreed that it's hard to legislate ethical behavior: "What reform needs to do is to put in place conditions-an architecture, if you like-that make it harder for banks to behave unethically. And this will only come from rules that ensure the greatest degree of transparency on Wall Street. Sunshine is the best disinfectant."

As the debate continued, the universe, in Rabbi Lippmann's equation, continued to rotate against Goldman. Since the SEC brought its charges, Goldman stocks have plunged 21 percent and the firm has lost an estimated $21 billion.