At the heart of the SEC's lawsuit against Goldman Sachs is the creation of a synthetic collateralized debt obligation (CDO). This type of security is one of the most complex out there. A hybrid of a derivative and asset-backed security, its consists of bonds that are paid cash flows based on the performance of other bonds, loans or securities that they reference, but are not directly backed by. For anyone who hasn't worked in the securities industry, that's probably confusing. Some who work in finance even find them strange. They don't serve any funding purpose, but act more to allow investors to bet for or against some asset or market. Without any clear social purpose, should they be banned?
First, it's important to understand what drove banks to create these complex securities in the first place. The Goldman fiasco is a perfect example. In that case, a hedge fund manager named John Paulson wanted to short -- bet against -- the subprime mortgage market in early 2007. Yet it isn't that easy to short the mortgage market. Mortgage-backed securities aren't like stocks, where there's a large supply of put options that allow buying a short interest in a company. So he asked Goldman Sachs to arrange a synthetic CDO. Other investors who wanted to bet on the subprime mortgage market would purchase the long interest and Paulson would buy the short. So the synthetic CDO created an opportunity for some investors to bet on the subprime mortgage market and others to bet against it -- without anyone actually investing in a single mortgage.
In his New York Times column today, Andrew Ross Sorkin renews the call to ban seemingly socially useless derivatives like synthetic CDOs. He says:
Why was Goldman, or any regulated bank, allowed to create and sell a product like the synthetic collateralized debt obligation at the center of this case? What purpose does a synthetic C.D.O., which contains no actual mortgage bonds, serve for the capital markets, and for society?
The blaring Goldman Sachs headlines of the last few days have given the public a crash course in synthetic C.D.O.'s. Many more people now know that synthetic C.D.O.'s are a simple wager.
And he quotes a former securities lawyer:
"With a synthetic C.D.O., it's a pure bet," said Erik F. Gerding, a former securities lawyer at Cleary Gottlieb Steen & Hamilton who is now a law professor at the University of New Mexico. "It is hard to see what the social value is -- it's hard to see why you'd want to encourage these bets."
Does the Government Ban Socially Useless Things?
But it's also hard to see why it matters how socially useful a financial product is. Since when does something have to make the world a better place for people to legally buy or sell it? It isn't hard to think of a vast number of products out there that have no social value. Remember the Koosh ball? That hardly earned its inventor the Nobel Peace Prize. Some may like the way breast implants look, but surely such purely elective cosmetic surgery serves no tangible benefit to society at large. Even fast sports cars like Ferraris are completely unnecessary to society. Indeed, on almost all roads in the U.S. the speed limit will preclude a Ferrari's owner from enjoying the vehicle's full potential.
The government response to a socially useless product isn't generally to ban it. It's to make sure it doesn't result in social harm. Speed limits serve this purpose for the Ferrari, for example. The same could be done with securities that are seen as being speculative and risky. If there's a significant potential for loss, then require investors to put up significant portion of cash to cover the downside.
Useful After All?
In the case of synthetic CDOs there may even be some socially useful purpose of keeping them around after all.
A Smaller Real Estate Bubble
Some have suggested that the existence of the synthetic CDO market prevented investors from overheating the mortgage market even more. My colleague Megan McArdle brought up this argument earlier while discussing this topic. By investors purchasing the synthetic CDOs instead of MBS, that took funding away from the real estate market, which would have inflated the bubble even further.
And on the other side of the coin, the short interests in synthetic CDOs also helped prevent the bubble from continuing to grow even larger. As the short positions built up, the mortgage market corrected itself more quickly, since investors began to realize their error sooner than they might have otherwise, had shorting been impossible.
So synthetic CDOs may have some positive social benefit after all. But even if they don't, there doesn't appear to be a precedent for the government to ban them just because they don't make the world a better place. Instead, precautions could be taking to ensure they don't get banks and investors in too much trouble.