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Michael Hlinka: All the regulation in the world won't make some people smarter

Money Talks is a business column from CBC radio.
By Michael Hlinka, CBC business columnist:
 
For the past few years, there has been serious discussion about new regulations for the American Financial Services Industry. It took one quarter of a trillion dollars of U.S. taxpayers' money to stop the system from imploding, so it's understandable that everyday Americans would think that there is something terribly wrong going on. 
 
And there are issues. No question there.
 
On Friday, the Securities and Exchange Commission announced a civil suit against Goldman Sachs for - and I quote: "Materially misleading statements and omissions." A lot of people are connecting the dots and arguing that this proves that more onerous regulation is necessary to prevent deals like the one Goldman Sachs put together. 
 
But I'm less sure. It seems to me that as long as people are willing to take on risk to earn higher returns, blow-ups like this are inevitable.
 
It all has to do with a deal - a very small deal, by the way - that Goldman Sachs put together early in 2007. Paulson and Company, a Hedge Fund, approached Goldman and allegedly said something along these lines: "We think there's going to a huge sell-off in the housing market, and we would like to profit from it. Can you help us?" 
 
The allegations are that Goldman and Paulson collaborated to select some of the riskiest sub-prime mortgages on the market, concentrating on regions like Florida, Nevada and California. Because these were the riskiest mortgages out there, they provided the highest returns. And that was the attraction, from the buyer's perspective. They were getting a higher return than if they put their money into safer mortgage products.
 
Goldman Sachs packaged these riskier mortgages into an investment vehicle called a collateralized debt obligation, or CDO for short.
 
Then after they created this product - you can think of it as a mutual-fund-like security whose underlying assets happened to be sub-prime residential mortgages - Goldman Sachs went out sold it, earning $15 million US in commissions. The biggest buyers were a couple of European banks, Germany's IKB Industriebank AG and Dutch-based ABN AMRO.
 
Here's where the allegations of fraud come in. In its marketing materials, Goldman claimed that an independent third-party had selected which mortgages would be in the structure. The SEC say this isn't true. It was Goldman Sachs and Paulson who made the decision about the investments, picking the very riskiest ones that they could find. By the way, Goldman Sachs disputes this claim. 
 
Of course, common sense should tell us that the riskiest investments are those that come with the highest returns. Which is exactly what the buyers were looking for, and what they were betting on. Goldman Sachs wasn't selling these products to naïve ma and pa investors.  They were selling them to sophisticated counterparties who must have believed as strongly in their point of view as Paulson and Company did in theirs. The European banks just happened to be wrong. 
 
I'm not here to argue whether, if indeed the allegations against Goldman Sachs are true, the company acted ethically. But I am going to say that at the end of the day, this was about someone making a good trade and someone making a bad one. And all the regulation in the world won't make some people smarter.

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