We have to get a grip.
The Securities and Exchange Commission allegations against Goldman Sachs, whether (1) true or (2) actionable in the end, show what a casino Wall Street has become.
Essentially, what Goldman was charged with doing at the behest of hedge fund manager John Paulson was creating a rigged game using complex financial instruments called derivatives.
The game went like this: Let's find a bunch of bonds built on subprime mortgages and place bets on them. Paulson wanted to bet against other investors that they would fail. If they did, he would win big.
But first, we're not actually going to buy the bonds ourselves, which typically are sold in the form of collateralized debt obligations, CDOs for short.
Instead, the cards we'll play with will be the insurance you can buy on those bonds to protect yourself if the bonds go bad. That insurance is sold in the form of credit default swaps.
(Why the term "swap"? You're swapping the risk of default with somebody else. When you buy home insurance, you're swapping the risk of a fire with the insurance company.)
Then, let's bundle up all those credit default swaps. Instead of a normal CDO containing the bonds themselves, let's put them into a "synthetic" CDO filled with credit default swaps.
As the subprime mortgage market collapsed, investment bank traders ran out of mortgage bonds to package and sell. So they turned instead to trading packages of credit default swaps on existing bonds. Trading in credit default indexes that bet on bonds without buying them has jumped 13 percent in the past three months to $1.2 trillion.
But here's where the alleged rigging really occurred. What Goldman is charged with doing is letting Paulson pick the underlying bonds to bet against. And then getting a supposedly neutral third party to sign off on the deal. And then not telling buyers who were betting that the bonds would not fail that Paulson was really the dealer of this three-card monte.
Goldman is proclaiming innocence based in part on it also betting against Paulson and losing more than $90 million, far outweighing the $15 million Paulson paid Goldman to set up the deal.
But if that's the case, Goldman not only helped fool other investors, it fooled itself. Do these super-sharp bankers really want to admit they didn’t know that one of their midlevel traders, one Fabrice Tourre, had set up the investment to blow up? What kind of oversight is that?
You can argue, as The Wall Street Journal editorial page does, that the investors on the other side of the deal weren't naïve, they were big boys who just didn't do their homework.
But that ignores that these sorts of deals, along with the collapse of the subprime CDO market and misuse of credit default swaps in general, made worse the financial system crisis.
Even though the average investor has not a scintilla of hope of being cut into a deal like Paulson set up, the Wall Street casino is not disconnected from the rest of us.
That's why the one crucial change that must be in the financial reform bill is the regulation of derivatives, which by and large were freed from oversight since 2000, when Congress passed and President Bill Clinton signed the Commodity Futures Modernization Act.
A regulation plan proposed by Sen. Blanche Lincoln of Arkansas, the chairwoman of the Agriculture Committee, has a lot to recommend it. Many of its provisions are even tougher than those proposed by the Obama administration.
Among other measures, banks and Wall Street firms would have to spin off much of their derivatives operations into separate subsidiaries. That would protect the rest of their banking and businesses from any huge losses.
For greater pricing transparency, most derivatives would have to be traded on an exchange. And a third party would have to clear the trades, to ensure that the bankruptcy of one party to a contract wouldn't drive the other out of business. And both parties would have to put up a certain amount of cash collateral.
Companies that sell derivatives would be regulated by either the Commodity Futures Trading Commission or the Securities and Exchange Commission.
Finally, any institution that deals in swaps would not have access to federal deposit insurance or the Federal Reserve's emergency borrowing window.
There is an important exception in the Lincoln plan. Farmers, food processors, airlines, trucking companies and others who use derivatives the traditional way, to protect them from swings in prices of raw materials, would be exempt from the regulations.
Of course, Wall Street is against the Lincoln plan.
Tough. It's time for a new pit boss in the Wall Street casino.