John Paulson is an interesting guy: He was one of a handful of hedge-fund managers who bet the mortgage-bond market would decline beginning in late 2006, and made billions from that bet. Here is where the SEC charges get interesting: Goldman allowed Paulson to help create the bond and to put some of the most risky mortgages in the portfolio, or mortgages that were most likely to default and tank the investment.

The SEC’s problem with all of this is not that Paulson went to Goldman to create the bond (Paulson wasn’t charged) or even that Goldman even sold the same instruments to investors, but that Goldman didn’t tell investors of Paulson’s involvement. Remember, because of his short position he had every incentive to pack the bonds with the crummiest mortgages that would later default, which they did.

Goldman’s excuse for all this is that it somehow lost money on the whole sordid affair (not sure how that happened) and that the SEC’s case is completely unfounded in law and fact. It left out, of course, that in 2007 Goldman also shorted the housing market like Paulson, and that contributed to its massive earnings that year, not to mention Blankfein’s paycheck which nearly reached $70 million.

Let’s just say there is no securities law violation here. That a judge that gets this case (presuming Goldman won’t settle, which if it hasn’t probably means the SEC wanted a lot by possibly making investors whole or something along those lines, which means Goldman could end up paying $1 billion) and throws it all out because Goldman deals with sophisticated investors who should know better.

After all, these big pension funds and hedge funds all have the means to have done their due diligence on the mortgages imbedded in the bonds, and they could have seen the risk they presented.

That all may be true, but what this case represents (and it’s a pretty good read for an SEC legal document) is a clear and compelling road map into how a firm that was once considered the gold standard of Wall Street behaves like a two-bit thug when money is on the line.

And if that notion holds with its clients, Goldman Sachs has got bigger problems than a bunch of name-calling journalists.

Read the whole thing here. John Paulson hasn’t been charged in this affair, but it is interesting that he has such a significant supporting role. As Big Government readers know, Paulson is the largest single donor to the Center for Responsible Lending, a leftist advocacy group that is part of a complicated web of non-profits and private investment funds. A leading executive of CRL is now at the Treasury Department, overseeing the proposed “Consumer Financial Protection Agency.” Paulson is becoming Wall Street’s Zelig, who keeps showing up in very interesting places.

Let’s begin with Washington. They want to take a broken health care system and make it worse by further injecting government. They’re going to raise taxes even though people are struggling with the worst economy in decades. They’ve started a job-killing trade war with China–our largest trading partner and our largest lender–to pacify Big Labor. They’ve given hundreds of billions of dollars of taxpayer money to insolvent and poorly managed, but politically connected, Wall Street banks and Detroit car companies in the name of saving our economy. We’ve continued to lose millions of jobs anyway. They’ve spent additional hundreds of billions of taxpayer dollars on a stimulus that was supposed to create jobs. Treasury Secretary Tim Geithner says there will be jobs some day, but should we really believe him? This is the same guy who thought subprime lending wasn’t a problem. The same guy who thought it made sense to give billions to lender CIT. How did that work? Oh, right, they’re bankrupt now.

Small businesses create most of the new jobs in our economy, but the agenda in Washington has been hostile to small businesses, with increased regulations and threats of new taxes. They have provided no incentives for small businesses to invest and grow. The banks and Wall Street, despite all the taxpayer bailout money, are not lending to small businesses. They’re hoarding capital for themselves or using it to speculate on commodities and short the dollar. Private equity capital is scared to invest because the government has kept asset values inflated to protect their friends at the banks. No wonder we still don’t have any new jobs even after opening the federal spigot to banks, auto companies and various recipients of ’stimulus’ dollars. We and our children will be paying that money back to the Chinese for decades, and we have nothing to show for it. Some people might call that indentured servitude. At a minimum, it is taxation without real representation because the politicians in Washington are obviously working for the lobbyists and not the voters.

Adding insult to injury, the new cap and trade rules will further destroy jobs and punish American corporations in the name of environmental purity. All these regulations will really do is transfer more billions of dollars from consumers and productive American companies to Wall Street banks that will make profits and fees trading carbon credits. (The only thing you have to know about cap-and-trade is that Enron was and early and ardent advocate of the scheme.) It’s just one more lie from Washington. They claim to be helping to save the environment, but they’re really just selling out consumers and jobs to help their friends on Wall Street.

The Fed has an even better set-up. Bernanke and his fellow governors can print and redirect as much of our money as they want and never have to face voters. They just need to convince the political class that they’re doing a good job. There were good reasons for the Fed to be set up independent of the political system. But, what happens when it becomes a hand-maiden to the system?

The most reasonable explanation for why this continues is to look at who benefits. Wall Street banks enormously benefit from this system. In fact, without this crazy system they would all be out of business because they’re insolvent. The only reason the big Wall Street banks still exist is because Washington and the Fed (i.e. taxpayers) bailed them out. Wall Street banks have hijacked the Fed and Washington because it was necessary for them to survive.  As former Fed Chairman Paul Volcker and others have said, banks are supposed to exist to serve the public. However, we now have a system in which the public and taxpayers serve the banks. This is not capitalism.

As CNBC editor Charlie Gasparino’s recent book, The Sellout, explains in great detail, the past several decades have transformed Wall Street from the greatest instrument of American capitalism to something that is now the greatest obstacle to American capitalism. Wall Street now exists simply to perpetuate itself and to pay its insiders as much as possible, even if that means sacrificing the rest of the American economy. In that sense, Wall Street is now very similar to the old state owned enterprises in the former Soviet Union. The main reason that the Soviet Union, a country rich in natural resources and educated workers, failed economically is because capital allocation decisions were made based on politics rather than economics. This is now what is happening in America. Capital is being allocated to failed, insolvent, and poorly run businesses on Wall Street because they are politically connected in Washington and at the Federal Reserve. Instead of allowing capital to flow through market mechanisms towards productive businesses in technology, services, manufacturing, or entertainment as just a few examples, too much capital is being directed by Washington and the Fed into unproductive Wall Street banks that are just using it to support their own bad investments and speculating to create short term profits without making long term investments that will create jobs or sustainable growth.

This is the real reason that despite all of the stimulus and bailouts from Washington, zero interest rates and money printing by the Fed, we are still losing millions of jobs in America, the unemployment rate is at a 27 year high, and our economy is not moving towards a real recovery.  The surging stock market and commodity prices are a slap in the face to all of us, demonstrating that there is plenty of money on Wall Street for speculation even as Main Street businesses and workers are struggling. While politicians beat their chests about terrorists or rogue states threatening us, the real Axis of Evil threatening our freedoms is right here in America. Washington, the Fed, and Wall Street have conspired together to hijack our economy and the future of this country. America was built on freedom, democracy, and market capitalism. If we want to get our country back on track, people need to stop complacently sitting around while Washington lies to us, the Fed steals from us, and Wall Street uses our own money to make huge profits at our expense. We need to stand up and demand accountability, honesty, the rule of law, and market based solutions to our economic problems. If we don’t do this, then we have nobody but ourselves to blame for economic misery and servitude. In my next column, I will put forth a few simple policy changes that could be made immediately to start moving things in the right direction again.

Those mandates, policy stemming back to the 1960s, were driven by compassion, but have turned out to be the chief cause for the current rampant rates of default, foreclosure, and economic pain striking particularly hard at low-income families.

Such is the story Charlie Gasparino tells in his new book, The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System. Gasparino notes that Cuomo as much as boasted in the late 1990s about forcing Fannie Mae and Freddie Mac to expand their subprime mortgage portfolios. Not slowing down, the George W. Bush appointed Martinez carried the ball forward with great speed, presiding over a period of time where Fannie and Freddie grew to hold a combined $1 trillion in subprime mortgages.

These government-sponsored entities were the tools the government used to try and expand housing opportunities to more and more Americans. A noble goal, but one executed by disastrous means. To begin with, the policies—explicitly set forth by members of Congress and the executive branch—were directly a part of creating the housing bubble. Gasparino nails it in his book, saying:

One of the ironies of the bubble Fannie and Freddie helped create through their guarantees and purchase of subprime loans is that it made housing less affordable, not more so. To own a home, working-class and poor families were now more reliant than ever before on the various gimmicks the mortgage business offered—the adjustable-rate mortgages and “no-money-down” loans that allowed families to live in their homes at minimal initial cost, only to have their mortgage payments skyrocket later.

Government housing policies of the past several decades were the cause of other problems as well, including creating incentives for banks to over securitize mortgages. The implicit support Fannie and Freddie had allowed it to borrow cheaply, spend freely, and act irresponsibly. You, the taxpayer, had their back.

All the while, corruption at the highest levels was rampant. Gasparino also writes of the “Friends of Angelo” scandal, where the CEO of Countrywide gave sweetheart deals to allies on Capitol Hill—including the top Senate banking and housing overseer, Chris Dodd.

Ultimately, the story of The Sellout might be summed up by this line from President Bush at the height of the bubble about the goal of expanding homeownership to more low-income families, particularly minorities:

There’s all kinds of ways that we can work together to meet the goal. Corporate America has a responsibility to work to make America a compassionate place.

That is the attitude that has sunk us today. The crisis started with compassion, it was driven by excessive confidence, and we are paying the price today.

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For more on this topic, also see my Reason Online article looking at other ways the government has been complicit in causing the crisis: The Myth of Financial Deregulation.