Were regulators careful or timid in their case against Goldman Sachs? Photograph by Michael Nagle / Bloomberg / Getty

In the late summer of 2009, lawyers at the Securities and Exchange Commission were preparing to bring charges in what they expected would be their first big crackdown coming out of the financial crisis. The investigators had been looking into Goldman Sachs’s mortgage-securities business, and were preparing to take on the bank over a complex deal, known as Abacus, that it had arranged with a hedge fund. They believed that Goldman had committed securities violations in developing Abacus, and were ready to charge the firm.

James Kidney, a longtime S.E.C. lawyer, was assigned to take the completed investigation and bring the case to trial. Right away, something seemed amiss. He thought that the staff had assembled enough evidence to support charging individuals. At the very least, he felt, the agency should continue to investigate more senior executives at Goldman and John Paulson & Company, the hedge fund run by John Paulson that made about a billion dollars from the Abacus deal. In his view, the S.E.C. staff was worried about the effect the case would have on Wall Street executives, a fear that deepened when he read an e-mail from Reid Muoio, the head of the S.E.C.’s team looking into complex mortgage securities. Muoio, who had worked at the agency for years, told colleagues that he had seen the “devasting [sic] impact our little ol' civil actions reap on real people more often than I care to remember. It is the least favorite part of the job. Most of our civil defendants are good people who have done one bad thing.” This attitude agitated Kidney, and he felt that it held his agency back from pursuing the people who made the decisions that led to the financial collapse.

While the S.E.C., as well as federal prosecutors, eventually wrenched billions of dollars from the big banks, a vexing question remains: Why did no top bankers go to prison? Some have pointed out that statutes weren’t strong enough in some areas and resources were scarce, and while there is truth in those arguments, subtler reasons were also at play. During a year spent researching for a book on this subject, I’ve come across case after case in which regulators were reluctant to use the laws and resources available to them. Members of the public don't have a full sense of the issue, because they rarely get to see how such decisions are made inside government agencies.

Kidney was on the inside at a crucial moment. Now retired after decades of service to the S.E.C., Kidney recently provided me with a cache of internal documents and e-mails about the Abacus investigation. The agency holds the case up as a success, and in some ways it was: Goldman had to pay a five-hundred-and-fifty-million-dollar fine, and a low-ranking trader was found liable for violating securities laws. But the documents provided by Kidney show that S.E.C. officials considered and rejected a much broader case against Goldman and John Paulson & Company.

Kidney has criticized the S.E.C. publicly in the past, and the agency’s handling of the Abacus case has been previously described, most thoroughly in a piece by Susan Beck, in The American Lawyer, but the documents provided by Kidney offer new details about how the S.E.C. handled its case against Goldman. The S.E.C. declined to comment on the e-mails or the Abacus investigation, citing its policies not to comment on individual probes. In a recent interview with me, Muoio stood by the agency’s investigation and its case. “Results matter,” he said. “It was a clear win against a company and culpable individual. We put it to a jury and won.”

Kidney, for his part, came to believe that the big banks had “captured” his agency—that is, that the S.E.C., which is charged with keeping financial institutions in line, had become overly cautious to the point of cowardice.

The Abacus investigation traces to a moment in late 2006, when the hedge fund Paulson & Company asked Goldman to create an investment that would pay off if U.S. housing prices fell. Paulson was hoping to place a bet on what we now know as “the big short”: the notion that the real-estate market was inflated by an epic bubble and would soon collapse. To facilitate Paulson’s short position, Goldman created Abacus, an investment composed of what amounted to side bets on mortgage bonds. Abacus would pay off big if people began defaulting on their mortgages. Goldman marketed the investment to a bank in Germany that was willing to take the opposite side of the bet—that housing prices would remain stable. The bank, IKB, was cautious enough to ask that Goldman hire an independent asset manager to assemble the deal and look out for its interests.

This is where things got dodgy. Unbeknownst to IKB, Paulson & Company improved its odds of success by inducing the manager, a company called ACA Capital, to include the diciest possible housing bonds in the deal. Paulson wasn’t just betting on the horse race. The fund was secretly slipping Quaaludes to the favorite. ACA did not understand that Paulson was betting against the security. Goldman knew, but didn’t give either ACA or IKB the full picture. (For its part, Paulson & Company contended that ACA was free to reject its suggestions and said that it never misled anyone in the deal.)

When S.E.C. officials discovered this, in 2009, they decided that Goldman Sachs had misled both the German bank and ACA by making false statements and omitting what the law terms “material details”—and that these actions constituted a violation of securities law. (The S.E.C. oversees civil enforcement of U.S. securities law and can charge both companies and individuals with violations. Its work can often be a precursor to criminal cases, which are handled by prosecutors at the Justice Department.)

Kidney was a trial attorney with two decades of experience at the S.E.C., and had won his share of courtroom battles. But the stakes in this case were particularly high. Politically, it was a delicate moment. The global financial system was only just recovering, millions of Americans had lost their jobs, and there was growing public anger about the bailout of the banks and car companies in Detroit. When Kidney looked at the work that had been done on the case, he found what he considered serious shortcomings. For one, S.E.C. investigators had not interviewed enough executives. For another, the staff decided to charge only the lowest man on the totem pole, a midlevel Goldman trader named Fabrice Tourre, a French citizen who lived in London, and who was in his late twenties when the deal came together. Tourre had joked about selling the doomed deal to “widows and orphans,” and had referred to himself as “Fabulous Fab,’’ a sobriquet that probably would not endear him to a jury. He was an easy target, but charging him was not likely to send a signal that Washington was serious about cracking down on Wall Street’s excesses.

Kidney could not understand why S.E.C. staffers were reluctant to investigate Tourre’s bosses at Goldman or anyone at Paulson & Company. Charging only Goldman, he said, would send exactly the wrong message to Wall Street. “This appears to be an unbelievable fraud,” he wrote to his boss, Luis Mejia. “I don’t think we should bring it without naming all those we believe to be liable.”