Sucker Me Once, Shame on You ...

Are you sick of hearing about Goldman Sachs (NYSE: GS) yet?

The company has been dominating the news lately thanks to the fraud lawsuit filed by the SEC. And while the overwhelming amount of coverage may seem like overkill, the hype from the case could (hopefully) push us toward some much-needed reform on Wall Street.

In fact, just yesterday, debate over the financial reform package finally opened in the Senate. Is the timing in relation to Goldman a coincidence? Not a chance.

Many of us here at The Motley Fool are hoping that Congress bears down to make the tough decisions needed to put our financial system on firmer ground. There's a slew of specific issues to be dealt with -- too big to fail, shadow banking, and everything else in between -- but those specifics can get a little overwhelming.

What's particularly interesting about the Goldman case is that it highlights one of the broader root causes of the problems on Wall Street.

Who's the sucker?
The SEC case against Goldman involves a synthetic collateralized debt obligation (CDO) and credit default swaps (CDS) written against that CDO. If that sounds like gibberish to you, that's OK, the important thing to understand is that none of those products mentioned are financing anything. They're all derivatives, or bets placed on something that was a financing transaction.

In these kinds of bets there is always a winner and a loser. In the case of the Goldman transaction in question, ABN Amro (now owned in part by Royal Bank of Scotland) and IKB Industriebank were the losers, while hedge fund Paulson & Co. was the big winner. ABN and IKB bet on a successful outcome for the CDO, while Paulson bet on failure.

If it all sounds a lot like wagers placed in Las Vegas -- "I'll bet that the next spin will come up red!" -- it's because it is. And as any good gambler on or off The Strip knows, bets are more easily cashed when you find a sucker to take the other side.

If only ABN and IKB had paid heed to Matt Damon's famous line from the movie Rounders: "If you can't spot the sucker in your first half-hour at the table, then you are the sucker."

It wasn't always like this
In the past, the financiers on Wall Street actually lived up to their name. That is, they were primarily concerned with helping entities procure financing. Now that they're facing tough questions about the nature of their business, executives are trying to claim that this is still the core of their business.

Just yesterday, on NPR's "All Things Considered," I listened to Goldman CEO Lloyd Blankfein defend Goldman's economic contribution by touting its capital-raising work. That'd be nice if it were true, but for most of the big banks, capital raising is small potatoes when compared to the much more lucrative business of trading.

Source: Company filings.

There's a significant difference between the two activities. Capital-raising activities are largely not zero-sum -- they help companies expand and drive broader economic growth. The trading activities, on the other hand, are largely zero-sum. That is, there is a winner and a loser, and the winner is better off to exactly the same extent that the loser is worse off.

And when big banks take their own stakes in these transactions, you have them putting their own capital base at risk on the outcome of a series of gambles.

Gamble away!
As a Las Vegas resident, I have no problem with gambling. But problems arise when the companies that are doing the gambling are huge institutions that are crucial to the functioning of our financial system.

So as we watch Congress try to come to terms with how to best reform the financial system, one of the key things I'll be watching is whether they put their foot down when it comes to separating the gambling functions of the big banks from the parts of those banks essential to our banking system. The banks in question will fight hard against it -- after all, these reforms would seriously cut down on paychecks to the C-suite -- but major banks like Wells Fargo (NYSE: WFC) and US Bancorp (NYSE: USB) have shown that it's possible to be very successful without a giant financial gambling arm.

In the end, there's definitely truth to the saying, "A fool and his money are soon parted." But when it comes to the financiers on Wall Street, our financial system will be safer if they spend more time financing and less time looking for the next sucker.