Both the mutual fund and hedge fund industries are under attack. But the one who will ultimately suffer from this assault is not who you may think.

Eliot Spitzer has stated on National Television that before he began his original Wall Street investigation he received verbal threats from a Merrill Lynch lawyer not to go poking his nose where it didnt belong. Well, Mr. Spitzer must be a glutton for punishment; he announced last week that he had the goods on some underhanded mutual fund/hedge fund dealings.

"The full extent of this complicated fraud is not yet known. But one thing is clear: The mutual fund industry operates on a double standard. Certain companies and individuals have been given the opportunity to manipulate the system. They make illegal after-hours trades and improperly exploit market swings in ways that harm ordinary long-term investors." OAG

Wall Street is corrupt? Say it isn't so Mr. Spitzer?

Don't get us wrong -- Spitzer is a hero amongst villains. To be sure, the man is a menace to the Street; something Greenspan should have been during the 1990s when OTC derivatives started to explode onto the scene, and something Levitt should have been the moment pro forma nonsense was being heralded as the gospel during CNBC's daily love fest. However, Spitzer's results do not speak louder than his words; investor's received nothing from Spitzer's first $1.4 Billion 'global settlement' and Wall Street admitted no guilt. In fact, beyond the nearly $500 million stuffed into State coffers, one has to wonder what good, if any, has come from Spitzer's 'historic' settlement...

As for Spitzer's new 'ongoing investigation' - Canary Capital Partners LLC has already donated $40 million to the cause - it alone is unlikely to change the way Wall Street conducts business. Rather, Spitzer's unrelenting attack against Street malfeasance lacks the regulatory capacity needed to force systemic change. At best, and to play off the arguments of Spitzer's would-be victims, Spitzer - using the 500 lawyers that follow his direction like mafia capos - is trying to extort money. In effect, "Pay us and we will allow you to continue doing business without hindrance."

An offer they don't want to refuse:

At first this may seem a rather peculiar thing to say. After all, Spitzer's tireless effort to reach the historic global settlement did seem to punish those institutions that broke the law. However, the analogy of the little Dutch boy trying to plug the leak in the damn with his finger is applicable: Spitzer temporarily plugged the hole, but the damaged structure wasn't repaired when he walked away.

If the Street can wipe its misdeeds clean by writing a check with a magnanimous stroke - something which Spitzer seems fine with as he hops from one battle to the next - than why don't the regulators simply come up with a 'dirty profits' tax? At the end of each calendar year Wall Street estimates the amount of money they stole from investors and pays 5% on the dollar to regulators, politicians, and lawyers - everyone is happy.

Trite as this may sound, it is difficult to see Spitzer's goal as being little more than a tax on crime. The problem here is that in the case of Wall Street theft the investor doesn't want to see a nominal fine levied against the perpetrators (a fine which, by the way, usually does little to recoup investment losses), but a change in the structure that allows the crime to happen with such frequency in the first place.

For example, instead of Spitzer attacking the regulatory agencies that have fallen asleep while policing mutual/hedge fund trading activity - agencies whose pockets do not run as deep as say Janus Capital - he instead sets his sight on The Street. This method of attack may on the surface appear productive - especially since Janus and Bank of America have retaliated to Spitzer's onslaught by conducting 'independent' reviews of "discretionary market-timing arrangements" and are promising to make 'appropriate restitution". However, to iterate a question that few seem to be asking - why are Janus, Bank of America and other mutual funds being investigated in isolation of those agencies that were already supposed to be policing trade? Investigation after the fact is likely to catch at most a few violators while leaving the majority unmolested. Consequently, is integrity likely to be restored to the marketplace through the occasional shakedown of a fraudulent dealer? Or would it be better served by attacking and dismantling the regulatory structure that allowed cronies such as Grasso (NYSE) and Pitt (former SEC boss) - under whose auspices the fraud took place in the first place - to be in charge of oversight? In sum, why attack the symptom (market manipulation by insiders) instead of treating the cause (a lax regulatory structure)?

Given that the Street doesn't mind paying out cash settlements so long as each settlement entails only a vague admission of guilt - an admission that in the case of analyst conflict of interests* is invariably qualified with "inappropriate communication" - Spitzer's remedy to systemic structural putrefaction appears to be nothing more than a fresh coat of paint. While there may, therefore, be the appearance of an aggressive change on the Street with each new fine levied, it is a change at the surface level only. The Street can raise commissions, develop new "services," and quickly recoup what has been lost...the fine will not be paid out of the Board of Directors' bank accounts but out of the pockets of future investors. Those directly responsible are not held accountable and the conditions under which these types of fraud can take place have not thereby been altered.

If it isn't fixed, break it:

Such is why the SEC's ongoing investigation (or 'review') of hedge funds is so important: it could, potentially, force hedge funds to register as investment funds, which would open the funds up to increased regulation. Furthermore, and again playing follow the leader with Spitzer, the SEC has just launched a new investigation into trading practices at top mutual funds. There is even chatter that Federal Regulators are going to jump on the new Spitzer bandwagon. These regulatory efforts could potentially bring about the new standards that would fix the damn.

And yes, the word 'potentially' is worth remembering. After all, thanks to lax new standards from FASB Citigroup will only have to consolidate $5 billion instead of the $55 billion originally estimated in off balance sheet assets (what is the other $50 billion doing?), the phrase "stock options may be expensed next year" threatens to become a decade old joke, and the front running issue at the New York Stock Exchange - thanks to Grasso turning the issue into a marathon - has already largely been forgotten.

Who is extorting Whom?

"Spitzer wins a $40 million settlement with Canary Capital." Did investor's really 'win'...Or has Spitzer's notched another victim in the great extortion scheme where, ironically, it is not the Street but ultimately the investor who is the one being extorted.

* Inappropriate communication or blatant conflict of interest? -- "Unless you anticipate Lehman getting I-banking business from them, I would rate them neutral with a price target of $20" Lehman Brothers

The Hope: "evidence uncovered in these investigations is being placed in the public domain to empower individual investors to recover funds that may be owed to them." Spitzer

The Reality: Investor Suits Against Wall St. Firms Rejected WP
Wall Street won a significant legal victory today as two federal judges issued separate rulings concluding that allegedly biased research reports from stock analysts were not to blame for inflating the market bubble that burst in 2000, wiping out trillions of dollars in investor wealth.