Is Wall Street Trading Illegal?

A recent article the Financial Times (http://www.ft.com/cms/s/0/2924dd32-9c2e-11e0-acbc-00144feabdc0.html#axzz1Px5XUpW8) is about JP Morgan being sued for misleading investors. The SEC claims that that JP Morgan along with other financial institutions sold CDOs (Collateralized Debt Obligations) to clients but were misleading their clients. Also mentioned in the article was the case where Goldman Sachs was sued by the SEC for basically the same thing but Goldman’s case was based on mortgaged backed securities. Goldman Sachs won the lawsuit but had to pay a bunch of money in the end (http://www.marketwatch.com/story/goldman-sachs-beats-the-sec-2010-07-15 ).

Now the real question is whether or not financial institutions were wrong. CDOs and CMOs (Collateral Mortgage Obligations) are basically large pools of either debt or mortgages that are broken into tranches. The first tranche will receive payments first and once the first tranche is paid off then the second tranche will receive payments until they are paid off. As you can see the first tranche has the least risk and therefore is more expensive than the last tranches which are the riskiest but are also cheaper. With expensive versus cheap realize that the more risk you take (more risk equals cheaper) the higher the expected returns. Regardless of what information was given you can see that CDOs and CMOs are risky assets compared to standard stocks and bonds. Whether the information was accurate comes down to valuation methods which I think are irrelevant because the types of investors that bought these CDOs and CMOs are other financial institutions who should understand that CDOs and CMOs have higher amounts of risk and therefore have higher returns that other forms of debt such as bonds. Something else to consider is that the institutional investors make up about 95% of the market where individual investors make up the remaining 5%. Do you really think that institutional investors who have bought CDOs and CMOs don’t understand what they are? If they don’t understand the general risk they shouldn’t be purchasing the assets.

At the end of the day companies like JP Morgan and Goldman Sachs are in the right. They are buying and selling assets just like they should be. No financial institution should be sued for taking a bet against risky assets regardless if their clients bought them or someone else’s clients bought them. Many people view Wall Street as a bad place where people make bets and in reality anyone who makes an investment is making a bet. Wall Street is a place for economic growth and any company is subject to risk whether it is a start up or a 100 year old company. The idea that investors who lost money are trying to sue the other investor who sold it is outrageous.

In conclusion new regulations such as the Dodd Frank Bill and frivolous lawsuits are hurting the US economy by restricting free markets because investors are taking on risk, losing money, and then complaining that they didn’t win. For every investment there is a winner and a loser. If people feel that the markets are too risky and not regulated enough I suggest you stick with fixed income assets such as bonds or CDs. Wall Street should be allowed to take on risk and let the free markets determine who survives.