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Goldman Sachs vs. SEC: 'Vampire squid' or 'doing God's work'?

Is Goldman Sachs a breeding ground for speculative booms and busts that have harmed America, as critics assert? Or does the work of Goldman Sachs create a vital foundation for economic growth? The Goldman Sachs-SEC case has reopened that longstanding debate.

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But the lawsuit means the American public is learning about a product that, on its face, is about speculation rather than financing real economic activity. The case is a narrow one, involving whether Goldman provided adequate disclosure to investors about how one 2007 deal was set up.

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The investment in question is called a "synthetic CDO" (collateralized debt obligation). It's called synthetic because Goldman created it simply as an opportunity for investors to take opposing bets on which way a package of debts – home loans in this case – would move in value. The investors were not taking a stake in actual home loans.

Goldman says it was a deal for sophisticated investors, who fully understood that one side would win and the other would lose. The SEC argues that the key investor on the "short" (downward bet) side of the 2007 deal had an influential role in designing the investment, a role that was not disclosed adequately.

Hedging business risks

To many defenders of Goldman and of Wall Street, such products serve a useful purpose even if they are two or more steps removed from the actual building or selling of houses. In this view, speculators can help a market function more efficiently. Often, by taking the opposite side of a given trade, they allow people like farmers or homebuilders to use so-called derivative investments to hedge the risks of their business.

To critics, synthetic CDOs and other derivatives have grown too large – many trillions of dollars in value – and too disconnected from the real economy. (Key players in the Goldman deal included a hedge fund and a German bank, not a US homebuilder or mortgage firm).

As a result, the critics say derivatives are as much a risk creator as a risk mitigator.

America's housing bust and financial crisis is Exhibit A that the financial sector has not been functioning perfectly as an engine of growth. Over the past decade, many Americans hoping for a thriving job market, stable housing market, and capital-gains in their retirement accounts have been disappointed.

The financial sector has accounted for a rising share of all corporate profits, and, judging by the financial crisis, the economy is no more stable as a result.

Paul Volcker weighs in

While not bashing all financial innovation, former Federal Reserve Chairman Paul Volcker entered the fray a few months ago at a forum sponsored by the Wall Street Journal.

"I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy," he complained. By comparison, the economy "was quite good in the 1980s without credit-default swaps and without securitization and without CDOs."

However they are viewed on Main Street or in ivory towers, investment banks have shown this week they can still trade and deal their way to big profits. Goldman reported a $3.46 billion quarterly profit Tuesday, and Morgan Stanley followed Wednesday with $1.78 billion in earnings.

Although Goldman topped Fortune magazine's recent list of "most admired" megabanks, broad polls of US public opinion show a significant tide of anger at banker bonuses and bank bailouts.