Freedomnomics

Article published Monday, April 19, 2010, at Fox News.

Time for the Government to Start Playing Fair

The government changed the rules of the game in the Goldman Sachs case.

By John R. Lott, Jr.

Fraud charges were filed against Goldman Sachs on Friday and the Obama administration is portraying the announcement as an attempt to bring greedy and corrupt Wall Street under control. Yet, the timing of the case looks like more than coincidence with the Senate about to start debating President Obama’s plan for financial regulation and with the president himself set to kick off his tour to push the bill on Thursday. The charges of fraud look more like the government changing the rules of the game than actual fraud occurring.

Politically the timing could not have been worse for Wall Street," noted Wall Street Journal Reporter Damian Paletta last Friday. "Goldman Sachs case could help Obama shift voter anger," pronounced a headline in the Los Angeles Times on Sunday.

Alas, President Obama sits atop an administration that doesn't seem to understand the first thing about financial trades. Markets make profits by minimizing price swings over time or minimizing current differences in prices. Investors make profits by buying low and selling high, not the reverse. That smoothes out price swings. Yet, Mr. Obama demonizes futures trading as increasing market instability and for causing the recent financial crisis when the opposite is true.

Goldman Sachs has been attacked because it sold bonds based on mortgage-backed securities (a collaterized debt obligation or CDO) that were picked because a hedge fund helped pick mortgages they thought were most likely to default. The hedge fund, Paulson & Company, was betting that those mortgages would go bad. It sounds horrible that the fund was filled with mortgages that someone thought were likely to go into default, but there is nothing wrong with that by itself. Neither Goldman Sachs nor Paulson & Company made these mortgages risky -- they just identified them. They separated out mortgages that they thought were particularly risky.

The first thing that people have to understand is that only the most sophisticated investors were involved in these trades. It was not as if Goldman Sachs was trying to convince retirees to hold these funds until they reacted old age. The director of the Securities and Exchange Commission enforcement division says that "The product was new and complex, but the conflicts were old and simple." Yet, the very complexity of these instruments and the fact that they were purchased by sophisticated investors make it much more difficult for the SEC to successfully argue that the sophisticated investors who bought them were being deceived or cheated.

The crux of the case is that while Goldman Sachs provided these sophisticated investors "extensive information about the underlying mortgage securities," it didn't disclose that Paulson & Company was selling the mortgages. The Obama administration claims that "to play fair. You have to provide full disclosure or you are going to face the consequences.'' But that is an entirely new rule. Why limit the principle to only to these CDOs? Does the Obama administration really want to require that the identity of everyone selling stocks be made public? Goldman Sachs notes: "As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa."

Ironically, if the administration really wanted to go after mortgage-backed fraud, it needs to look no further than the government. As Alan Greenspan testified two weeks ago Greenspan also witnessed, first hand, this pressure on banks to issue mortgages that they didn't want to sell: "I sat through meeting after meeting in which the pressures on the Federal Reserve -- and on, I might add, all of the other regulatory agencies -- to enhance lending were remarkable."

Unfortunately, Fannie Mae and Freddie Mac’s problems didn't just end with them pressuring banks to make risky loans. As one academic journal, The Journal of Business & Economics Research, put it: “In 2003, the Office of Federal Housing Enterprises Oversight (OFHEO) investigated Fannie Mae and found a culture of corruption, arrogance, and pervasive accounting violations in the company. Executives at Fannie Mae cooked books to pocket an extra twenty-seven million dollars in bonuses.”

In order to help sell high-risk home mortgages, Fannie Mae and Freddie Mac mislabeled these risky mortgages as AAA. Investors still purchased these mortgages even when the fraud began to be clear because Fannie Mae and Freddie Mac, with the financial support of the federal government, stood behind the mortgage backed securities they issued. It was America's taxpayers who were left holding the bag. Even assuming what that the government is right that Goldman Sachs did something wrong, they have nothing on what Fannie Mae and Freddie Mac did.

Amazingly, a financial crisis created by government is being used to demonize private lenders who only gave out risky loans because of government pressure. Yet, Democrats continue to reward Fannie and Freddie with even more funds. Meanwhile, Goldman Sachs finds that it is charged with fraud because the Obama administration has changed the rules on what it means to "play fair." It is time for the government to start playing fair.

John R. Lott Jr. is a FOXNews.com contributor. He is an economist and the author of "More Guns, Less Crime (University of Chicago Press, 2010), the third edition will be published in May.".

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