Those evil synthetic CDOs

By Felix Salmon
December 30, 2009
Yves Smith has another long broadside today against Goldman Sachs, Morgan Stanley, and any other bank which made money on synthetic CDOs. She links approvingly to yesterday's NYT editorial, which concludes:


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Yves Smith has another long broadside today against Goldman Sachs, Morgan Stanley, and any other bank which made money on synthetic CDOs. She links approvingly to yesterday’s NYT editorial, which concludes:

Unsavory and dangerous practices like firms betting against their clients need to be thoroughly investigated. They won’t end until Congress adopts ambitious financial reforms.

Narrowly speaking, this is false on both counts. What we’re talking about here is simply the world of structured products, in which broker-dealers use derivatives (always referred to in the press as “complex derivatives”, whether they’re complex or not) to create financial products for which their clients have some need or demand. Because derivatives are a zero-sum game, it’s trivially true that any bank selling such a product to its client is, at least in the first instance, betting against that client. If the client wins, the bank loses, and vice versa. Such practices may or may not be unsavory and dangerous, but they don’t need to be thoroughly investigated: everybody knows how derivatives work.

What’s more, such practices aren’t going to end if and when Congress adopts ambitious financial reforms. Structured products are with us, and they’re here to stay. Personally, I consider the overwhelming majority of them to be part of the enormous bucket labeled “harmful financial innovations”, and I would be very happy if they disappeared. But both the banks and their clients are utterly convinced that these derivatives are very useful things indeed, and as a result the only question is how they’re going to be regulated, not whether they’re going to exist.

Now it’s true that at the margin, the synthetic CDOs put together by Goldman were more unsavory than many other structured products, because of the information asymmetry involved: Goldman knew what the sausage was made of better than its clients did. But it’s worth noting, here, as Gillian Tett has explored at book length, that most banks putting together synthetic CDOs actually lost billions of dollars on those instruments. Now that we’ve pilloried Merrill Lynch for being so stupid as to get synthetic CDOs spectacularly wrong, we’re moving on to pillorying Goldman Sachs for the equal and opposite crime.

Remember that while Goldman did indeed retain a large short position in these synthetic CDOs, most of the shorts who fueled the market were not broker-dealers at all, but rather fund managers: Michael Lewis wrote a much-celebrated story about one such manager, Steve Eisman. Eisman was a client of the investment banks just as much as the investors on the long side were, and just as prone to problems of information asymmetry.

By far the most systemically-devastating decisions made by Wall Street over the course of the credit boom were the ones which ended up losing banks billions of dollars — and the ones which involved lending real money to real individuals buying real homes they couldn’t afford. Side bets in the derivatives market were ultimately a secondary or even tertiary phenomenon, and it’s easy to overstate their importance.

Yes, it would be good if the derivatives market were regulated somehow: I hope it is. But so long as there are profitable investment banks playing in this market, those banks are at heart going to be making money by betting against their clients. The banks know it, the clients know it, and most of the time all of them are happy — until, of course, they’re not. If bankers’ behavior in the the derivatives market ever changes, it’s more likely to be a function of having to deal with an increasing number of Chinese clients who get upset if they lose too much money, rather than a function of financial reforms being pushed through Congress.

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