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Kate Kelly and Jon Hilsenrath had a story on the front of the Wall Street Journal yesterday demonstrating the real problems with the revolving door between Wall Street and the regulators. The essence of the story is this: New York Fed Chairman Stephen Friedman is a director at Goldman Sachs (NYSE:GS), a company for which he has a main role in oversight.

Despite this conflict of interest, Friedman bought shares in Goldman Sachs in December, profiting to the tune of $1.7 million.

The WSJ article states:

The case illustrates what a tangle of overlapping interests can arise at a hybrid institution like the New York Federal Reserve Bank, especially as the U.S. government, in addressing the financial and economic turmoil, grows ever more deeply enmeshed in American business and banking.

Mr. Friedman, who once ran Goldman, says none of these events involved any conflicts. He says his job as chairman of the New York Fed isn't a policy-making one, that he didn't consider his purchases of more Goldman shares to conflict with Fed policy, and bought shares because they were very cheap.

Last week, following questions from The Wall Street Journal, Mr. Friedman, 71 years old, disclosed he would step down from the New York Fed at year end. In an interview, he said he made the decision because the waiver letting him own Goldman stock and be a Goldman director expires at the end of the year. He added: "I see no conflict whatsoever in owning shares."

The video of Kelly explaining her story should provide some additional color on this topic (see original post on Credit Writedowns).

Yves Smith of Naked Capitalism caught on to this story Monday morning and has already given a well-informed view of why this is a big problem.

Recall that in the waning days of the Bush Administration, it wasn't clear how bank friendly the new Administration would be. Even thought Geithner was Treasury secretary designate, there was some discussion in the press as to the divergent views within the Obama economic policy team, and whether that would create creative friction or conflict. Conflict (or having Volcker, who is not a fan of innovative finance, have a strong voice) could have kept bank valuations at bay.

Thus while Goldman's stock was arguably cheap, cheap stocks can get cheaper. One of the important inputs to the wisdom of going long would be knowing how bank friendly the new Administration's policies would be. To think that Friedman didn't have some insight into that question by virtue of his advantaged position is naive.

This should make it plain that the Obama administration is going to be walking a tightrope between its Wall Street-friendly inclinations and its need for populist rhetoric. Which side wins is very much up in the air. You should recall that Goldman has taken a lot of heat for its cozy role with government. Last year, it was a favored recipient of government largesse via the AIG bailout. Yet, incongruously, Goldman representatives were the only Wall Street participants to the government’s own bailout discussions when a course of action was decided.

I should also point out that the web of interconnections does not end with Wall Street and the regulators, it extends to law firms and the regulators as well. Over 15 years ago, I worked at a top-tier law firm in Washington D.C. with a well-regarded securities practice. When I worked there, this firm’s Securities practice main partners were former regulators who had 'changed sides.’ While my experiences in law were eons ago and the quote I provide below is from an article from 1998, little has changed since then (Just today, a partner from Jones Day was appointed FDIC General Counsel).

In the latest swing of the regulatory revolving door, Bill McLucas, the SECs recent enforcement chief, and Martin Kuperberg, former head of the SECs New York City office and most recently chief of the NASDs key New York office, have left for positions on the other side of the fence.

McLucas, a 20-year SEC veteran who spent the last nine years as enforcement chief, recently joined Wilmer Cutler & Pickering, a Washington D.C.-based law firm with specialties that include representing securities firms in anti-trust and SEC enforcement cases. The law firm already boasts a host of other top SEC alums, including the late Arthur Matthews, the SECs former enforcement deputy; Mary Ann Smythe, formerly head of the SECs Division of Investment Management; and Brandon Becker, former SEC director of market regulation.

Obviously, we want Wall Street experience at our regulators so they understand the firms and financial products they regulate. Moreover, we want qualified people not to be afraid that their service to government precludes them from taking on well-regarded roles in private industry. This is why much of the mixing between Wall Street, law firms and regulatory agencies is healthy.

Nevertheless, the conflicts of interest in this revolving door policy are large. They have served to severely undermine the integrity of the regulatory wherewithal of government and have fostered a deep sense of mistrust on Main Street.

Unfortunately, I do not have a ‘fix’ for this problem, but I imagine it is one that will garner ever more attention if the banking industry continues to receive special favors.

Sources

Disclosure: I have no financial stake in Goldman, long or short

Source: Goldman Connection at NY Fed: Major Conflict of Interest