Andrew Ross Sorkin of the Times surely knows the textbook answer to this:
When Wall Street Deals Resemble Casino
Wagers
...But if there is a larger question, it is this: 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?
That may be a larger question, but Mr. Sorkin never answers it. Instead, we get this explanation of derivatives:
One side bets the value will rise, and the other side bets it will fall.
It is no different than betting on the New York Yankees vs. the Oakland
Athletics, except that if a sports bet goes bad, American taxpayers
don’t pay the bookie.
“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.”
Hard to see the social value? Let me help - speculators and short sellers aid in the process of price discovery, so that market participants can use "real" prices (and I emphasize the airquotes here for reasons explained below) to make decisions. [What, was 'Casino Royale' on television recently? Here is a NY Times op-ed that also leans on the flawed casino analogy.]
So for example - imagine it is 2007, there is something Alan Greenspan is calling a global savings glut, and all around the world investors have become persuaded that they must own US residential mortgage-backed securities ('RMBS').
In a world with no synthetic CDOs, would-be investors would have to bid for the existing supply of mortgages, driving up prices and encouraging every builder in America to build more houses and every mortgage originator in America to make new loans. If and when that bubble pops, the result will be huge over-building in the housing market and a serious unemployment problem as people who thought they could make a career in construction or mortgage origination migrate to new professions.
But suppose we allow the creation of synthetic CDO's. By itself, that does nothing. But suppose there also exists a large group of well-financed investors who are prepared to put big money behind the notion that US residential mortgage-backed securities are over-priced and bound to fall in value.
Ah hah! Now the RMBS bulls and bears can slug it out in a virtual world. Investors who feel they must own these bonds can buy synthetic versions from bears who are happy to sell to them. Actual prices may not change and neither real-world builders nor mortgage originators will get a price signal exhorting them to expand the nation's housing stock.
Then, when the bubble bursts, all that happens is that large sums are transferred from the bulls to the bears (had the bubble not burst, the opposite would have occurred). The wholesale layoffs in construction and the massive overbuilding of the housing stock don't occur. And if no bank bet too much (If!), there would be no bailouts.
I exaggerate for effect, of course - in reality, the huge demand for RMBS would fuel both the creation of a synthetic market and expanded real-world construction. However, to the extent that the bears were able to put their money to work to hold down prices, the magnitude of the overbuilding should have been mitigated. Put another way, prices are more likely to float above their "correct" value when bears have no mechanism that lets them express their opinion with cash.
So, is the use of synthetic CDO's different from betting on the Yankees or the A's? Well, the value of the price signal that the Yankees have a more powerful team than the A's is far from clear to me. I'd hate to say it is useless, but I can't think of a use.
But here is gambling question I am sure I can answer. Consider a casino (as alluded to in the headline) where bettors are putting their money or the red or black of the roulette wheel. I am confident that (assuming it is a fair, properly balanced wheel) the price signal conveys no socially useful information.
(That said, I will indulge my inner pedant and add that if there is a flaw in the roulette wheel that prompts it to favor a particular color, there is an excellent chance that the price action will deliver that signal to the casino operator, as sharp bettors discover the flaw and put their money down on the winning side.)
So - housing market side-bets can provide a useful guide to real world behavior in a way that does not translate to baseball betting or casino wheel.
Mr. Sorkin presses on with two more dubious but related points.
The Securities and Exchange Commission, in
its suit, says that Mr. Paulson asked Goldman to help create a
synthetic C.D.O. of lousy mortgage loans that he selected so he could
bet that they would go down and then profit on their fall.
That's what they say. But part of Goldman's response is that hindsight is 20/20. In 2007 Paulson was a guy with an opinion about housing bonds, just as Nouriel Roubini was a guy with an opinion about the financial system. So what? With the passage of time, their opinions were vindicated and others were not. But who knew events would play that way in 2007? Sophisticated investors who believed that RMBS represented good value also understood that other market participants disagreed and that the nature of a synthetic CDO required both bears and bulls in the deal.
Paulson might look at a particular bond with a bearish slant and persuade himself that since it hadn't fallen much yet, it had a lot longer to drop. A bullish investor might look at the same bond and convince himself that since it hadn't fallen much yet, it would lead the way in the next rally. After the fact, they won't both be vindicated, but that doesn't mean that the bull should credit Paulson with prescience from the outset.
Put another way, after tonight's game between the Yankees and the Athletics, it will be perfectly obvious that one side bet correctly and the other side did not. But if the A's go on to win (heaven forbid!), that will hardly prove that everyone who bet on the Yankees was an idiot.
One last gasp from Mr. Sorkin:
Try this mental exercise: Imagine if, a few years ago, an influential
investor like Warren
Buffett, bullish on real estate, had asked Goldman to develop a
synthetic C.D.O. made up of undervalued mortgages.
Now, imagine if Goldman had found John Paulson to take the opposite side
of the trade and, lo and behold, a year later Mr. Buffett turned out to
be right and Mr. Paulson lost his shirt. Would you call that fraud?
Would you be very upset?
Maybe not, but Mr. Paulson sure would be. And he might be inclined to
sue over it, especially if he found out that his bet had been rigged
against him from the start. Which brings us back to the financial
legislation being debated in Washington.
First of all, Warren Buffet has been a legendary investor for decades, so his involvement in the deal would clearly be material. Paulson was a legend in the making who is now famous for having called the housing turn; back in 2007, he was one more housing bear no one had heard of.
As to the notion that the bet "was rigged from the start", well, that is tricky. Mr. Paulson (or Mr. Buffet in the hypothetical above) is not, for example, a Cisco insider structuring a short sale of Cisco to dupe some outsiders. The bears have an opinion, but they have no material inside information unavailable to the bulls.
A synthetic CDO must, by its nature, have bulls and bears. Saying to one of the bulls, "by the way, do you fully understand that someone is selling what you are buying?" would not have added to their understanding of the deal. Telling them that the buyer was someone they had never heard of would not have expanded their useful data set either. On the third hand, telling them that the other side was being taken by the legendary Warren Buffet would have given many people pause (at a minimum, an investor would pause long enough to figure out how to explain to his boss that he is smarter than Buffet.)
Well, that is the Goldman side. I should add this - if the SEC can establish that Goldman made a deliberate effort to mislead the investors about Paulson's role, it would certainly suggest that Goldman thought there was something worth hiding. But that evidence is a bit thin.
"REAL" AND "CORRECT" PRICES: I used the quotes up above because of a common mis-apprehension of the nature of market prices. The notion of efficient markets is not that prices are always right - it is that prices are wrong in ways that cannot reliably be predicted in advance.
Just for example, tonight, some people will study the rosters and starting pitchers and bet on the Yankees; others will do the same thing and bet on the A's. Just now, the "right" price might show the Yankees with a 60% chance of winning; by about 4AM ET tomorrow, that price will be absurdly wrong, since the Yankees will have either won or lost. But at this moment in time, it is a perfectly reasonable price and tomorrow morning it would be unfair to say the losing bettors were buffoons who were duped by the winners (We save "buffoons" for Red Sox fans).
Similarly, back in 2007 different people had theories about the likely developments in the US housing market. Obviously, some were right and others wrong. Paulson was right, and good for him.
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