They fell for it because they assumed that the federal government would prevent fraud. They fell for it for the same reason that Bernie Madoff's investors fell for his scam -- the U.S. Securities and Exchange Commission is supposed to prevent these sorts of things. We pay our taxes so that a government agency will do our research for us and ensure that sales pitches are proper and accurate. We do not want to abide by the age-old aphorism "caveat emptor" -- buyer beware. We do not want to be self-informed buyers. We want to be spoon-fed information by our investment advisers, no matter how ridiculous the information.
The only problem is that the federal government has proved itself utterly incapable of preventing fraud. Instead, the federal government provides the illusion of security to buyers while allowing sellers to do anything until proven guilty in a court of law.
The easy solution would be to reinvigorate a healthy sense of self-reliance in investors and buyers -- tell Americans to do their own research, to do business with those they trust.
President Obama's solution is to create more regulations -- regulations that will undoubtedly be ignored by bad actors and that will undoubtedly hamper honest businessmen. On Tuesday, the Huffington Post reported that the House is considering legislation, backed by Obama, that would allow the Federal Deposit Insurance Corp. (FDIC) to interfere in private derivatives contracts in cases of emergency. In short, if a company like Goldman Sachs were to buy a derivative from Morgan Stanley, and Morgan Stanley were to go under, the government could stop Goldman Sachs from collecting the derivative.
In theory, this sounds great. In practice, it creates an incentive for Morgan Stanley to sell too many risky securities. Then, if Morgan Stanley fails, the federal government would allow Morgan Stanley to skate on its financial obligations.
This all sounds far more complicated than it actually is. The bottom line is this: When the government assures market actors that they do not have to live up to their obligations -- basic obligations like research or paying their obligations -- the market collapses. That is not a failure of the free market. It is a failure of a government-perverted free market. Financial thieves are the same as all other thieves: they do not respect the law. More financial laws will not make financial liars more honest any more than gun laws prevent criminals from acquiring firearms. In fact, more financial regulations will only provide market participants the same false sense of security that brought about the current crisis.