A controversial $40-billion government program to buy toxic securities from ailing banks has a flaw that law enforcement and financial experts say could allow traders to illegally profit from inside information.
Critics of the program say that without adequate safeguards, traders could use the tens of billions of dollars provided by the government to manipulate prices and exploit the price swings in other trades.
Because the government is providing 75% of the program's money -- $30 billion -- the manipulations could lead to significant losses by taxpayers.
"It is a conflict by design," said Neal Barofsky, the special inspector general for the banking rescue program who has urged tighter controls on the nine trading firms selected to participate.
The Treasury Department, which is in charge of the program, says it intends to closely monitor trading activity to prevent illegal insider trading and profiteering at the expense of the public interest.
But Barofsky said the government probably stands little chance of beating Wall Street at its own game.
"The Treasury cannot possibly match wits with the innovation and aggressiveness of Wall Street," he said. "If you give them a set of rules and there are technicalities and legal loopholes and things we haven't thought of, they are going to find that out, not because they are bad, but because that is what they are supposed to do. They are supposed to seek out profits at all costs."
The program, known as the Public Private Investment Partnership, or PPIP, allows the nine investment firms to use the government money and $10 billion in private funds to buy up toxic securities held by banks.
The firms, chosen last month from a field of about 100 applicants, have already begun assembling pools of private investors to buy the securities, composed of troubled mortgages that have festered on banks' ledger books and hampered their return to health.
The toxic securities, which could total $2 trillion, plummeted in value during last fall's credit crisis and became virtually impossible to sell because of uncertainty over their worth.
Under the government's plan, traders would jump-start the market by making offers to banks for the securities, thereby setting fair prices for the securities and trading them on the open market. Sales could begin as soon as this month.
The chosen investment firms could earn large profits or bonuses on those trades, but their risk of losses is largely borne by the taxpayers, who are putting up most of the money.
The danger is that traders in the government program could wield enormous influence in the market -- and there are no explicit restrictions on how they could use that influence to profit inside deals of their own.
For example, a trader could privately buy up groups of toxic mortgages on the cheap then later drive up the price by purchasing similar mortgages using government money. The practice, known as "front running," could be technically illegal, but the firms are not barred from coming into the program with such securities and then trading them, Barofsky said.
"If being a trader in the program gives you information that enables you to do trades on the side, that isn't going to go over very well with the public," said Lynn Turner, former chief accountant at the Securities and Exchange Commission. "The inspector general is right."
The practice of using side deals strikes many experts as a return to what created the financial crisis in the first place.
During the Wall Street boom years, massive profits were made by companies trading in unregulated side deals, while ordinary investors earned a fraction of those profits in regulated markets.
Now, the Treasury Department seems to be explicitly creating its own miniature version of that system, said Mark Sunshine, senior consultant at First Capital, a commercial lender based in Florida.
"[President] Obama has not required any tougher rules in the PPIP program at a time when he wants tougher rules," Sunshine said.
Barofsky said a simple solution would be to construct a "wall" between traders in the public program and those in other parts of the firms, thus preventing the manipulation of prices with inside information.
But while the Treasury Department is still finalizing its rules for the program, it has rejected the wall, saying it would dissuade veteran traders from joining because they would be barred from making other trades. The program would be left with junior traders -- the only staff members that investment companies would be willing to isolate from their main businesses.
In a letter to the inspector general, Treasury officials said that investment firms privately told the department that they would not get involved in the program if there was an attempt to wall it off.
The Times asked all nine firms about their current trading practices in mortgage-backed securities and their plans for internal controls once trading begins using taxpayer money.
The firms declined to answer all of the questions, including identifying who would lead their trading teams.