So what will the financial sector look like after whatever financial reform bill passes? I want to raise some specific points.

Taxing

There's a lot of talk that the the potential negative effects of concentration and size in the financial sector can be corrected through the tax system. That we will get a tax on liabilities and/or a tax on TARP recipients to shrink the financial sector, and we can make our income tax more progressive to make sure that well all reap the windfall.

Doing these backwards: first off, many people at the top end of finance don't usually pay the income tax. They pay a 15% capital gains tax because their income is considered carried interest. Warren Buffet pays less in as a percent in taxes than his secretary. The average tax rate of the top 400 earners in 2009 was 16.6%. Etc. When it comes time as a liberal society to determine how to set up our tax structure so that those who have benefited the most from a deregulated and bailout financial industry will in turn benefit the least-advantaged members of society, it gets set up so that those who run massive hedge funds trading leveraged paper to each other contribute less than a teacher or a nurse. (Even behind a veil of ignorance, Magnetar can rip your face off.)

Here's a 2007 report from EPI and here's Dean Baker in February 2010 lamenting that we can't move this after a financial crisis. (I would assume this would make for a great tea party talking point.) Either way, here's hoping that the loophole is closed this year.

I've heard of a tax on liabilities and TARP coming for a long time, and I will believe it when I see it. It's worth noting that this doesn't sound like official policy since it would be an obvious "competitive disadvantage" for our firms, and anyone on the Hill who has been asked if it's Treasury's idea to shrink the largest banks, which are all bigger as a result of the financial crisis, the answer is a complete dodge.

Size

And let's be clear, the bailout was a series of events that concentrated the market. From Raj Date's paper on the financial bailouts and resolution authority, here is how the bailouts look aggregated:

Of the bailout money and the debt guarantee programs, 75% of each went to the largest firms. That left the rest of the banking community to do their best to survive.

The Franchise

There's a lot of talk about franchise value, and yes commercial banks had things like Regulation Q which prevent competition in interest rates and investment banks had their set commissions. I'd also probably add that during this postwar many firms were able to largely self-finance their expansions through their profitability, which kept a check on Wall Street from being able to do all that much that was interesting (my mind is nowhere near made up on what caused the calm). But I'd like to add that leaving the Great Depression, Roosevelt was able to keep a surprisingly diverse and robust system of banking in place. Especially compared to the number of people, banking and government, who wanted to intensely concentrate it for economic planning purposes. From David Kennedy's Freedom From Fear:

Faced with effectively complete collapse of the banking system in 1933, the New Deal confronted a choice. On the one hand, it could try to nationalize the system, or perhaps create a new government bank that would threaten eventually to drive all private banks out of the business. On the other hand, it could accede to the long-standing requests of the major money-center banks-especially those headquartered around Wall Street- to relax restrictions on branch and interstate banking, allow mergers and consolidations, and thereby facilitate the emergence of a high concentrated private banking industry, with just a few dozen powerful institutions to carry on the nation's banking business. That, in fact, was the pattern in most other industrialized countries,. But the New Deal did neither. Instead, it left the astonishingly plural and localized American banking system in place, while inducing one important structural change and introducing on key new institution...[Glass-Steagall, FDIC]

We didn't leave the New Deal with a large concentration of powerful banking interests in play. Disclosure rules of the SEC and exchange reform removed a lot of the informational power the biggest players exerted. And there were clear distinctions between what kind of business lines FDIC insurance and the deposit window would support. Lord knows what the final bill will contain, but I worry we are definitely entering a brave new world here, and not replicating a financial system of the 1950s updated for today.

Mike Konczal is a fellow with the Roosevelt Institute and a blogger at rortybomb.wordpress.com.

Shaping the future with today's choices.

This is a criticism of Goldman -- or an explanation of Goldman-like behavior -- from a Goldman admirer. I admire the company, its people, and the quality of its work. I think it is a great company and unique for its industry in its ambitions to be a good company. It is probably one of the two best financial businesses in the world. I also think that Goldman's behavior and point of view suggests something larger about the finance sector and its place in our economy.

First, the facts around the Goldman/SEC matter don't seem to be much in doubt. There were a series of issues of synthetic CDOs constructed by Goldman working with John Paulson (the famous hedge fund owner who made no secret of his desire to short sub-prime mortgages). These were sold to investors who were not told very much of Paulson's role. Paulson did short them; the investors did lose money. Goldman thinks it did nothing out of the ordinary here and that any other finance company would have done the same thing; the SEC says it committed a crime. I agree with Goldman.

Second, it is important to understand the culture of a deal/trading business. These are not the relationship businesses of decades ago built on trust and service. Every older, retired investment banker you talk to will lament the loss of "relationship banking." Not a single younger banker -- say, under 45 -- will have a clue what you are even talking about. To say it again, these are deal/trading businesses. There are all kinds of jokes about the cultures of these businesses -- "If you want a friend, get a dog"; or "What is a client for, except to stuff bad securities into?"; "I want partners with a feral instinct for profit" -- but the ground truth is that these companies are transactions businesses, they are made up of people who do deals; they are, institutionally, a composite of many, many deals; and their cultures are built around the winning and losing of all of these deals. A consequence is that these kinds of companies see the world as divided into predators and prey and, lest you be in any doubt, Goldman partners are not prey.

Playing in this world is a bit like playing with tigers. Every once in a while a child slips through bars of a zoo and goes to play with the tigers and is invariably eaten. The tiger is then shot. But the tiger was just doing what tigers do, and "what tigers do" does not include considering the child's interests. If you -- an investor -- choose to play with Goldman, you will get exceptionally good service but understand that the odds of Goldman considering your interests deeply are roughly the same as the child and the tiger. Not to put too fine a point on it, but that kid investment banker who put together the now famous CDO deal did not think his career would turn on how empathetic and caring he was about investors.

Third, it is unlikely that Goldman will lose to the SEC in this dispute or settle with the SEC. The deal was legal, the securities were legal, and the marketing looks to me to have been legal. Everyone who bought into these deals had to know that their only purpose was to provide a way to bet for or against bad mortgages. There was no one hunting for absolute return here. In my mind, given all of this, the legal issue is going to turn on a very subtle question: did Goldman secretly construct this security so that it was much more of a one way bet than investors were led to believe?

That is a very hard case to make and barring clear evidence that makes this case it feels like a stretch to argue that Goldman violated disclosure laws. At the same time I doubt if Goldman will settle. Its reputation has taken a big hit, and it cannot afford just to let this lie there in the background with a vague settlement. The SEC has taken a big risk with this case.

So, fourth, if this is not a legal issue, is that all there is to say about it?

I was going to say in this blog that Goldman -- perhaps uniquely, given its ambitions -- should be ashamed of itself. But a whole raft of conversations have convinced me not to say that. Goldman doesn't have permanent interests like clients anymore; like all other trading companies it has deals and trades. (The younger investment bankers I talked to found it incomprehensible that the thought would even arise.) Of course, these companies will trade against their clients; of course they will construct one way bet securities; of course they will work with Lehman to create ways of hiding major balance sheet problems; of course they will{C}

help the Greek government report misleading financial statistics; and of course they will reverse engineer rating company models to establish artificially high ratings. That's all just life out there with the tigers.

I think a big global financial market needs these kinds of companies. I see them as heat-seeking missiles targeted at over-priced, over-hyped stocks and bonds, at flaws in governance and regulation, and at bad corporate management. They also go long -- hunting opportunities others won't risk, and seeing innovations long before others do. Overall -- "net, net" as they say in the game -- they make markets more efficient at lower cost than any other way. (Although the cost and the compensation is way out of line, but I will focus on that in a couple of days.) It's good to have wild tigers out there. You just don't want to be tilling your field real close to their habitat.

Which is my point. It is insane to have a public policy allowing the mixing of these kinds of businesses with more agriculture-like banking businesses, with clients who need to trust their bankers with savers and genuine borrowers. (This is not sarcasm. People in real business can't spend all their time figuring out how to outrun tigers.) These cultures don't mix. And they haven't in the big mergers. In every real case I know of, this cultural gap remains unbridgeable. Back when the tiger businesses were relationship businesses focused on mergers and acquisitions and strategic advice to CEO's, allowing these combinations maybe made some sense or did little harm. But no one noticed as these businesses became deal/trading businesses. And in these circumstances the combination is dangerous.

It is insane to encourage inordinate leverage in these businesses, or allow anyone to think in any way that the risks of these businesses are back-stopped by the taxpayer. All leverage does here is allow the amplification of trades and risks; and combining high leverage with a taxpayer guarantee is lethal. Let the tigers be tigers but don't give them a nice comfy home at night.

And, it is probably wrong to have these businesses structured as limited liability public equity companies. But, then, if a normal common shareholder wants to bet that she has well aligned interests with one of the tigers -- or partners -- who the shareholders have granted unlimited upside and not much downside, good luck. I'm not making that bet.

So I'm completely with my friend Paul Volker. The big divide that has emerged in the last 25 years in finance is between business businesses and trading/deal businesses -- farmers and tigers. We would take a big step away from the next financial crisis if we made this divide one of the principles of financial reform.

Roosevelt Institute Senior Fellow and Braintruster Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama's Office of Management and Budget (OMB) transition team.

Spitzer and Black argue that the Goldman revelations underscore the need for serious financial reform.

For those who have spent years investigating fraud, it was no surprise to hear that Goldman Sachs, the (self-described) jewel of Wall Street, is the latest firm to emerge from the financial crisis with tarnished reputation. According to a lawsuit brought by the Securities and Exchange Commission, Goldman misrepresented to its customers the quality of the toxic assets underlying a complex financial derivative known as a "synthetic collateralized debt obligation (CDO)."

As you may now have heard, the story involves a pair of Paulsons. As CEO of Goldman, Hank Paulson oversaw the buying of large amounts of CDOs backed by largely fraudulent "liar's loans." When he became U.S. Treasury Secretary, he went on to launch a successful war against securities and banking regulation. Hank Paulson's successors at Goldman saw the writing on the wall and began to "short" CDOs. They realized that they had an unusual, brief window of opportunity to unload their losers on their customers. Being the very model of a modern investment banking firm, they thought that blowing up their customers would be fine sport.

John Paulson (unrelated), who controls a large hedge fund, also wanted to short CDOs and he, too, recognized that there was a narrow window for doing so. The reason there was a profit opportunity was that the "market" for toxic mortgages only appeared to be a functioning market. It was, in reality, a massive bubble in which ratings and "market" prices were grotesquely inflated. The inflated prices were continuing only because the huge players knew that the prices and races were fictional and were covering it up through the financial equivalent of "don't ask; don't tell." According to the SEC complaint:

In January 2007, a Paulson employee explained the company's view, saying that "rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while 'real money' investors have neither the analytical tools nor the institutional framework to take action."

We know from Bankruptcy Examiner Valukas' report on Lehman that the Federal Reserve knew that the "market" prices were delusional and refused to require entities like Lehman to recognize their losses on "liar's loans" for fear that it would expose the cover up of the losses. Valukas reports that Geithner explained to him when interviewed (p. 1502) that:

The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in "collateral damage" by demonstrating weakness and exposing "air" in the marks.

Goldman and John Paulson worked together. One of the key things to understand about shorting is that it is extremely valuable if other major players short similar targets at the same time. By helping Paulson take advantage of Goldman's customers (the ones that lacked "the analytical tools" to avoid being hosed), Goldman not only earned a substantial fee, but also aided its overall strategy of shorting the toxic paper.

Goldman created a deal in which John Paulson played a major role in selecting the toxic paper that would underlie the investment. He picked assets "most likely to fail - quickly" and studies show that he was particularly good at picking the losers. At this juncture, there is some dispute as to whether ACA was complicit with John Paulson and Goldman in picking losers (ACA initially invested in the synthetic CDO, but then transferred the risk of loss to German and English taxpayers).

What isn't in dispute is that Goldman, ACA, and Paulson all failed to disclose to purchasers of the synthetic CDO that it was designed to be most likely to fail. The representation was the opposite: that the assets were picked by an independent entity with their interests at heart (ACA). Goldman claims it's a victim because while it intended to sell its entire position in the synthetic CDO to its customers, it was unable to sell a chunk. One feels the firm's pain. Goldman tried to blow up its customers to the tune of over $1 billion, but were unable to sell them the last $90 million in exposure.

The Goldman scandal raises several important questions: Did John Paulson and ACA know that Goldman was making these false disclosures to the CDO purchasers? Did they "aid and abet" what the SEC alleges was Goldman's fraud? Why have there been no criminal charges? Why did the SEC only name a relatively low-level Goldman officer in its complaint? Where are the prosecutors?

In a December New York Times op ed, we, along with Frank Partnoy, asked for the public disclosure of AIG emails and key documents so that we can investigate the deceptive practices exposed by the Goldman case. Goldman used AIG to provide the CDS on most of these synthetic CDO deals (though not the particular one that is the subject of the SEC complaint), and Hank Paulson used tax payer money to secretly bail out Goldman when AIG's deceptive practices drove it to failure.

The SEC's Goldman fraud complaint points to fundamental problem in the financial sector that has been at the root of the financial crisis -- one that still exists today. The market is not transparent. It has been fraudulently manipulated to enrich managers. Investors lack clear information to make decisions about what they are buying. A continuing absence of real consumer protections makes people like those trying to obtain mortgages before the crash understand that they were, in many cases, being ripped off. According to internal Goldman Sachs e-mails, the company vice president, 31-year old Fabrice Tourre, did not really understand the complex deals he was making. And yet we note that many of these Goldman-style deals were "insured" by AIG. Without transparency, regulators cannot properly see all these kinds of deals in the aggregate. So they can neither stop the fraud nor prevent catastrophic results.

We applaud the SEC lawsuit, but it will not solve the problem. Unless our financial system is reformed to put adequate protections and checks and balances in place, we can expect this kind of fraud to continue. Financial executives will continue to take risks they do not understand. Those who control the flow of capital will continue to churn out profits with socially disastrous consequences.

Two things to put on your schedule -- and we couldn't help but notice how closely they are related. We're talking Wall Street scandals and the man who exposes them...yee-ha!

1) Roosevelt Institute Braintruster Bill Black will appear tonight on Bill Moyers Journal to discuss the sociopathic culture of Wall Street as Obama makes the case for financial reform. Black's interview follows on the heels of his pull-no-punches testimony this week on the Lehman fraud (yes, that was Dick Fuld sitting right next to him!) Black and Eliot Spitzer's recent post on the Lehman scandal is a must-read: see "Time for Truth: Three Card Monte is for Suckers." Stay tuned for their post on Goldman, coming later today...

Check your local PBS listings here.

2) On April 29th, the Museum of American Finance will unveil its latest exhibit, "Scandal!: Financial Crime, Chicanery and Corruption that Rocked America." The exhibit will feature photographs, documents, and other materials tracing the history of American financial scandals from the Crash of 1792 to the crisis of 2008.  Along the way, it will highlight some of the country's most notorious swindlers, including Charles Ponzi, the man who perfected what became known as the Ponzi scheme.

Leena Akhtar, the Museum's director of exhibits and archives, explained that the exhibit's purpose is to "connect recent events to what has happened in the past, and to educate students, investors, industry professionals and aspiring Wall Street professionals about the history and consequences of dishonesty in government and finance."  As the Senate prepares to debate financial reform, this exhibit should provide a timely reminder that this latest crisis had deep roots and that real changes are necessary to keep the cycle from repeating itself.

The opening reception for the year-long exhibit will be held on Thursday, April 29th, from 5 to 7 PM.  The museum is located at 48 Wall Street and is open Tuesday to Saturday from 10 AM to 4 PM.  For more information, visit www.MoAF.org.