“Fraud at Last”
April 20, 2010, 4:00am

By Robert Kuttner — Huffington Post.

The SEC’s fraud case against Goldman Sachs could represent a turning point in the public understanding of the great financial collapse, its politics and its remedies. Or not.

Far-seeing critics such as Bill Black, Jamie Galbraith, and Tom Ferguson, have long maintained that at the root of this crisis was not just regulatory failure or mistaken financial strategies but deliberate fraud. The SEC’s suit is a civil one, not a criminal charge, but it’s a start. Before this is over, senior financial executives need to be brought before the bar of justice and the existing system and its biggest players need to be broken up.

Consider the behavior that was at the very center of the collapse. At the retail level, mortgage companies backed by Wall Street’s largest financial behemoths encouraged naïve customers to submit what the trade called “liar loans.” Often the loan officers helped them fill out the application. In other words, the basic business model was built on fraudulent misrepresentations.

The retail mortgage companies could unload this paper because credit rating agencies colluded with them to turn very high risk loans into triple-A securities. This is also fraudulent. But none of the credit rating companies (which are regulated by the SEC) has yet been charged with fraud.

Then, further down the line, outfits like Goldman Sachs both turned these dubious loans into securities, and bet against the securities and helped hedge funds make even more complex bets, collecting both trading profits and fees. This, says the SEC in the complaint, is fraudulent. It took nearly two years for what has been documented in more than a dozen books and innumerable articles about the crash to be turned into a formal government enforcement action.

The SEC’s suit should be just the beginning. Between what we learned in the special examiner’s report on Lehman Brothers, and what will come out in the Goldman suit (if the SEC is not stampeded into a premature settlement) we should be able to document that fraud was at the core of the entire business model.

That’s why the Obama-Dodd-Frank legislation, though a decent beginning, is far too weak to achieve the reforms that the system needs. Meanwhile, the very same banks that exist only thanks to the Administration’s largesse, and which are paying record bonuses while the rest of the economy still suffers, are putting on a full court press to kill even the modest reforms. The Republicans and some Democrats have been working with bank lobbyists to weaken the bill even as GOP leaders like Mitch McConnell attack the measure for inviting future bailouts.

Politically, though Obama is entirely right to slam the Republican hypocrisy, Obama and Dodd have given the Republicans ammunition. The measures to limit abuses in derivatives trading are far too weak; “resolution” of failed banks would not necessarily break them up; too-big-to-fail is a bigger problem than ever; and the Administration is not fighting hard to get investment bankers like Goldman out of the conflicted business of trading for their own accounts.

President Obama has pumped up the rhetoric somewhat, but his willingness to take on the banking industry is still far from Rooseveltian. No wonder the voters are still confused by Mitch McConnell about which is the party of Wall Street.

Paul Volcker was right when he quipped that the last useful innovation produced by the banking system was the ATM machine. For something like three decades, the financial part of our economy has become a world unto itself, consuming over 40 percent of all corporate profits by 2006, the last year before the crash.

During the postwar boom, when the economy grew at nearly four percent a year for almost three decades and America became a more equal society, banks really were close to public utilities. Commercial banks made modest profits by evaluating the creditworthiness of corporate customers and making loans; thrift institutions provided safe places for savings and sources of mortgage borrowing; and investment bankers and true venture capitalists underwrote stock and bond issues, taking risks only with their own money. There were no hedge funds, no private equity–and no spectacular collapses. Securitization was unknown, and derivatives were a small, specialized and well-regulated corner of the financial system used mainly by farmers and others who dealt in primary products and need to hedge against price swings.

We need a drastic, radical simplification of the financial system. That means breaking up large institutions that are too big to fail, and breaking the rice bowl of ones that add nothing to broad economic welfare and efficiency other than an opportunity for the own enrichment at the general expense. To get there politically, we first need to expose the full extent of the fraud, and we need a Democratic Party that reverts to its New Deal role as the party of regular people rather than its Clintonian role as a second party of Wall Street.

Charming as it was to see former President Clinton admit that mistakes were made on his watch when it came to de-regulation of derivatives, that is only the beginning of redemption. Clinton’s people did not take a dive on this and on kindred issues because they made technical errors, but because the whole administration was in bed with Wall Street.

Happily, the politics of this epic struggle are starting to move in a more progressive direction. Senator Blanche Lincoln, chair of the Senate Agricultural Committee (which shares jurisdiction over derivatives regulation) is now taking a tougher line on regulation. It doesn’t hurt that she faces a tough re-election as well as primary opposition from the left.

After the great collapse, the smart politics as well as the right thing to do is to root out the fraud that is the essence of Wall Street’s business model–and dare the Republicans to oppose it. The deeper problem is not the Republicans but the fact that much of the Democratic Party is not sure that it wants to drastically simplify the financial system. President Obama has lately been finding his voice as a progressive. Let’s see if he truly rises to the occasion.

Robert Kuttner is author of “A Presidency in Peril.” He is co-editor of The American Prospect and a Senior Fellow at Demos.