Did Wall Street bet on failure?

It would seem to be an obvious conflict of interest for a Wall Street firm to create an investment product, sell it to its clients and then bet that the product would fail.

Yet according to a story published in The New York Times on Christmas Eve, when many investors would have missed it in the last-minute holiday rush, that is what some financial firms did just as the mortgage market was beginning to collapse. According to the story, investigators in Congress, and at the Financial Industry Regulatory Inc. and the Securities and Exchange Commission, are examining whether the firms breached securities laws, or rules of fair dealing, when they created and sold mortgage-linked debt instruments and then bet that the value of the instruments would collapse.

The Times reported that Deutsche Bank AG, The Goldman Sachs Group Inc., Morgan Stanley, Tricadia Inc. and others created and sold synthetic collateralized debt obligations to their clients and then sold short against them.

That raises the question of whether the companies misrepresented the quality of the securities they packaged, and even whether they deliberately structured the packages so that they would fail and their firms would profit.

The firms may argue that they often hedge their bets, but that would be an explanation for their short-selling activities in the CDOs only if they held substantial amounts of them on their own books and retained exposure to the risk of a market collapse.

If they retained no exposure, they were simply betting that the securities would fail, in effect betting against the interests of their clients, and in addition, betting on insider information.

This would be like the manager of a prize fighter making a large bet against his own man in a championship match, knowing that his fighter had an injured hand.

Whether the Wall Street firms had significant amounts of the failed CDOs on their own books will no doubt be one avenue of examination for the investigators.

If the allegations that the firms were betting against their clients while they knew the mortgage market was beginning to collapse prove to be true, it will be another black eye for Wall Street, adding to the damage done by the mortgage meltdown. It will further erode the confidence of the investing public that they can get a fair shake from Wall Street.

If this is how Wall Street firms treat their best customers, who supposedly were the main purchasers of the CDOs, then what chance does the small investor have of getting a fair deal? If the deck is stacked against the pension funds, endowments and foundations, the little guy doesn’t stand a chance.

The damage will be even greater if the investigators find that the CDOs were structured to fail.

Even without that, the short selling of CDOs by the firms that created and sold them to clients will strengthen the arguments of those who say that Wall Street needs tighter regulation and tighter supervision.

If as a result of the investigation, the financial reforms working their way through Congress are made more stringent, especially in relation to the creation and trading of derivatives, the Wall Street community will have only itself to blame.

And if the financial reforms can’t be delayed until this investigation is completed, Congress will have to revisit the issue if the charges are substantiated.