Goldman Sachs and the Broken Windows Theory

My friend David Gerstman of Soccer Dad sent me this piece.

activities and transactions, and the general population’s anger at the bailouts and the lingering recession grew, the tide finally appeared to shift. On April 16, the Securities and Exchange Commission announced an action against Goldman Sachs for fraud in the sale and marketing of one of its CDOs. Shortly after, the Senate woke up from its slumber and hauled executives from Goldman into a hearing to castigate them for the unethical behavior in the CDO market. Finally, the Wall Street Journal reported that the Department of Justice was investigating possible criminal actions against Goldman for its mortgage trading activities.

Goldman Sachs, with its many connections to government officials at the Treasury and the Federal Reserve, had previously seemed to be, if not above, than at least closely tied to the law in the world of securities. Now that it is under wider scrutiny, many of Goldman’s practices are being called into question. Goldman’s (and other banks’) damaging practices in the mortgage and CDO markets are finally receiving harsh criticism.

Based on the reaction in the press and across the country, it appears that many people are gratified that the enforcement agencies are finally directing their attention to the scene of the crime. Surprisingly, certain right-leaning representatives, including the New York Post and Mayor Bloomberg, argued that the SEC actions and new proposed financial regulations were wrong. They argued that by seeking to enforce the securities laws against Goldman or by imposing stricter financial regulations, the SEC or Congress would damage Wall Street and the local economy.

I agree with the broken windows sentiment in financial regulation. We'll all remember that Rudy Giuliani made the broken windows theory a staple in his attack on crime. In this theory, the authorities make a renewed vigor in stopping low level crimes. That's because if you clean up the streets it also encourages bigger criminals to stay away.

Nowhere is this theory more accurate than in finance. The author of the piece spent twenty years in high finance working on such things as Collateralized Debt Obligations. So, it may be their perspective that makes them think that Goldman Sachs is the equivalent of a "broken window." While I agree with the sentiment, I totally disagree with its application. In the mortgage crisis, here is how we should have used the broken windows theory.

Here's what a standard so called "broken window" looked like. Let's say you are a janitor. You are trying to buy a property for $190k. In order to get you qualified, I, the mortgage pro, have to say your income is $50k. I get you a no income verification loan. I say you make $50k when you really make signifcantly less. That's what I do. You get the loan. Both of us just committed fraud. You know you don't make that much and so do I and yet, that's what I put down and you signed. That's fraud.

That seems very small time but it occurred on a regular basis. It was the beginning of the crisis. Had that activity been made an example of, the crisis might have been averted. It was these sorts of loans that made up a massive part of these bad CDO's, MBS', and all other complicated financial instruments. Had we cut them off, we would have also gone a long way to averting the crisis.

It could have been done also. The reason that this went on is because no one was ever punished. Had the government made an example of one of these folks, a lot of these loans would have stopped. That is the way to accomplish the broken windows theory.