Will the Morgan Stanley Probe Help Goldman?

If a dozen different people walked into a supermarket and openly stole groceries, as employees and security personnel watched and said nothing, is it still a crime? A similar question could be asked regarding the behavior of investment banks that sold securities that they also bet against, while regulators sat idly by.

Reports today indicate that the government has begun expanding its efforts beyond just Goldman Sachs. One of its chief competitors, Morgan Stanley, is also being investigated by federal prosecutors. Yet the government's ramping up its offense against the financial industry instead of focusing on a single target could actually hinder its hopes to win a case against an investment bank.

Morgan Stanley is being investigated for the same reason that Senators were so angry with Goldman in a recent hearing. They believe the banks sold complex securities called collateralized debt obligations (CDOs) that they essentially bet against. The government believes this is a conflict of interest.

And Morgan Stanley won't likely be the end of this effort. The Wall Street Journal quotes William Blair analyst Mark Lane saying:

"Every investment bank has been receiving subpoenas about CDOs and the marketing of CDOs," Lane said. "They've been exchanging information with regulators as they look at how products are being marketed in this area, related in particular to the residential housing market."

Lane added that the investigations will likely have some influence on financial-services reform and that the damage to any individual firm's reputation is much less now given that the probes are much broader.

Indeed, if all firms were behaving in this way, then it's hard to differentiate just one or two as being worse than the others in this regard, even if you believe their actions were inappropriate. And it could also weaken the government's prosecution. A piece from MarketWatch asserts:

By expanding its probe outside of Goldman Sachs, the government may be undermining its case against Goldman. Fraud is fraud, but when a practice is prevalent across an industry, it becomes accepted. Suddenly the burden shifts from the alleged fraud to regulators who should have stepped in if the practice was unacceptable.

The reality is CDO growth was a relatively new development in the markets. Banks played in a gray area of regulation, and did so for a decade.

Is "everybody was doing it" a valid defense in court? Not if everybody was breaking the law, but it might make bad behavior seem a little less objectionable. If regulators sat by and did nothing, should securities firms really be held accountable for acting in this way? Not if you would frown on prosecuting those dozen people who were allowed to steal food from a supermarket.

(Nav Image Credit: Wikimedia Commons)