Opinion

Felix Salmon

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:

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.

Comments
7 comments so far | RSS Comments RSS

Sure, we’ll ban this as soon as we ban states running lottery programs for their citizens, a much more obvious negative expected value proposition.

Posted by Beer_numbers | Report as abusive
 

It’s nice to read such a level-headed account. The truth is that if you as an investor in late 2006/early 2007 and you decided to invest in a synthetic CDO stuffed with subprime mortgage paper, it didn’t take a malicious structurer to make your investment turn out poorly. Any investment of that kind was going to blow up. So whether or not Goldman tweaked a few things to make their deals worse than the average deal is kind of a minor detail. And in any case there was no regulation for these things – as long as it passed muster with the rating agencies, it could find a buyer. That was the nature of the market. If the rating agencies aren’t culpable for their spectacularly wrong ratings, then I don’t see how the banks could be culpable for structuring something to obtain the rating.

Posted by o_nate | Report as abusive
 

Respecfully disagree with your characterization of derivatives as a zero-sum game. Banks — almost always — hedge their end perfectly, such as by buying the reference equity in a total return swap. (The bank would make its money through the financing charges issued against the customer.) In fact, until I learned about Goldman’s synthetic CDOs, I was unaware of a dealer taking a true principal position in a derivative with a customer. But it does help explain — I think — how GS was able to get short exposure to this par of the market.

Posted by Anonymous | Report as abusive
 

“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.”

terrific point, Felix.

Posted by KidDynamite | Report as abusive
 

The issue here is that a derivative transaction can be established where the manager is acting against the interests of investors, but investors are not aware of this fact. Presumably there are conflict of interest exposures in the deal docs, but I wonder whether they are very illuminating on this point.

If you went to the race track, you know the bookie is acting for his own interest. But if you are putting your money in what appears to be a managed investment, most people will assume that the manager is working on your behalf.

If these structures were bond funds, then the actions of the structured product manager would likely be a breach of fiduciary duty. Investors likely invested in these products assuming they were like traditional investments, when this was not the case.

Posted by hps | Report as abusive
 

Blimey Felix, who’ve you been listening to? Have you been Joshed? He was trying to seduce me the other day but I wasn’t really having any…very interesting charming talkative guy but too upfront persuasive for a contrary stick in the mud like me. Anyhow someone has surely fried your brains; nobbled I’d say.

The specious line of argument in para 1 and para 2 would have you straining at the leash to skewer it, if anyone else came up with it. At least, it would, if you were a tethered dog with a skewer taped to his paw, which, if your picture is to be trusted, is not the case.

Or are you trying a devastatingly accurate Megan impersonation, for macabre satirical reasons of your own?

“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.”

OK I’ve got that: this is a set up for a guilt-by-association pseudo-argument. Batty old Yves has lost her marbles and is willing to endorse any old nonsense uttered by those NYT bozos. We can skip the detail in the NC post and clobber the NYT instead and then crazy Yves is up a gum tree, pelting us with leaves and twigs, and yammering. Let’s see how that scenario pans out.

“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)”

Well no. Narrowly speaking, this is about synthetic CDOs, which *are* brutally complex, (possibly even complex in a strict computational sense, see http://www.cs.princeton.edu/~rongge/deri vative.pdf). Does the NYT in the cited article, not just “the press”, use the phrase “complex derivatives” and mean it, or not? You seemingly couldn’t be arsed to look it up and neither can I. If the client abuse charge stands up (the ultimate point of the trumping match currently going on between McClatchey, NYT, NC, and Tavakoli), then one might indeed want to reform it. If you are interested, a previous generation of legislators, in the aftermath of the ’29 crash, reached the conclusion that there had indeed been client abuses back then. The outcome was the 1933 Securities Act, aka “Truth in Securities Act”. I suppose it depends on your view on the perfectibility of man, but it’s not such a stretch to suppose that the same sorts of thing might have been going on in the OTC derivatives market, 70 years later, is it? Have you seen the perfunctory disclosure typical in the docs? The estimable alea provided an example over at NC just now. It might as well be a licence to kill (the client).

“to create financial products for which their clients have some need or demand.”

Ahh, the “blame the buy side” meme makes a shy little appearance. Not the whole truth, and convenient shelter for the sell side; it has recognisable fingerprints on it, that idea.

“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.”

A point possibly not lost on the goofy NYT hacks, and most definitely not on Yves Smith, former consultant to derivatives firms.

“If the client wins, the bank loses, and vice versa.”

Almost got the idea there, but alas the moment is lost…

“Such practices may or may not be unsavory and dangerous, but they don’t need to be thoroughly investigated:…”

Huh? Isn’t there generally thought to be some sort of nexus between OTC derivatives trading and a certain expensive world wide financial convulsion that you may have heard about, or indeed witnessed, not that long ago? You may think that such an account is just conventional wisdom, but it would be worth arguing that decidedly heretical point in a bit more detail. Read that blithe dismissal again, mate, and have a ponder.

“…everybody knows how derivatives work.”

Err, are you absolutely sure about that? This is the point in the argument where the conflation of complex derivatives and derivatives is supposed to pay off, but it doesn’t really. It just leaves you looking like some kind of benign amnesiac. Maybe you you should have put “the bruised and bailed-out survivors (GS, MS, UBS, ML/BOA, Citi, RBS, AIG, Narvik town council etc etc) of the 2005-08 OTC derivatives clusterboff might now have a dim inkling of the risks inherent in such instruments. Others (BS, LEH) will never get a chance to leverage their new found understanding”. I will concede of course that this formulation doesn’t really fit your general line of argument, but I believe it to be nearer the mark, though OTC derivs are very far from being the only factor in the pile-up, of course.

Basta per stasera! I can’t go on at this length about the succeeding paras but believe me they don’t look too good either. Have a chew.

You are normally so much better than this; I can’t believe you haven’t been fiddled with.

Posted by RichardSmith | Report as abusive
 

The story you link to – great reading by the way – points out that pre-bust demand for synthetic CDOs was completely outstripping actual numbers of mortgages on the market, in direct response to which certain unethical major synthetic sellers generated more product to, as it were, satisfy that demand.

This would imply that somebody who issued them was not only betting against future values of said re-rated BBB CDO bundles qua AAA ones, but went about fabricating loads of additional pseudo-collateral out of raw cloth.

There’s a word or two for synthesis as evil as this. “Illegal” is the most polite one that comes to mind here.

Of course there were some losers among CDO issuers – most of them were never quite as off-the-map evil as GS, so destined to lose they were. If the pillory is all Goldman ever gets for their particular misdeeds leading more or less directly to precipitation of the mortgaged-backed CDO crisis, one might say they were getting off pretty damn lucky.

Posted by HBC | Report as abusive
 

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