Tuesday, April 20, 2010

Side Bets That Do Nothing?

Roger Lowenstein writes:
Wall Street’s purpose, you will recall, is to raise money for industry: to finance steel mills and technology companies and, yes, even mortgages. But the collateralized debt obligations involved in the Goldman trades...raised nothing for nobody. In essence, they were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house.

The mortgage investment that is the focus of the S.E.C.’s civil lawsuit against Goldman, Abacus 2007-AC1, didn’t contain any actual mortgage bonds. Rather, it was made up of credit default swaps that “referenced” such bonds. Thus the investors weren’t truly “investing” — they were gambling on the success or failure of the bonds that actually did own mortgages. ...But no actual bonds — and no actual mortgages — were created or owned by the parties involved.

...is this the proper function of Wall Street? Is this the sort of activity we want within regulated (and implicitly Federal Reserve-protected) banks like Goldman?

It is true that this didn't directly finance a single house. But let's see what this type of activity can do that gambling in a casino doesn't.

We are talking about the construction and selling of a synthetic collaterized debt obligation (CDO). Regular CDOs are created when people gather a whole bunch of mortgages together and then redistribute the incoming payments to other parties. So, my mortgage payment doesn't necessarily go to one particular company, but rather there are 100 mortgages in a pool and one party has the right to the first X dollars of payments every month, then somebody else has the next X dollars, and so on. If you are the first person getting paid, then you are probably likely to get your money back, which was why those portions, called tranches, of the CDOs were rated AAA. Tranches that got paid later were lower rated.

So, what's a synthetic CDO? It consists of credit default swaps. Credit default swaps are arrangements or instruments where one party bets (I'll get back to that) mortgages will payout and another party bets that it won't. They then package up bets on all these different mortgages into a security that mirrors the way the actual CDO containing the actual mortgages changes in value. Hence, you create a synthetic CDO.

Now, regarding the bet part. If you want to be blunt about it, then your life insurance company is betting that you won't die for a long time. Your auto insurance company is betting that you won't get in an accident. Malpractice insurance companies are betting that a doctor won't get sued. Health insurance companies are betting you won't get really sick. Yet, we all recognize that these so-called bets have legitimate value.

How does a synthetic CDO create legitimate economic and social value? Relatively simply. If I'm an investor who buys a CDO, then I might want to take out insurance that my loans don't fail. So, I use a CDS to do that. That way I can hedge my risk of default on CDOs. (In fact, the problem with AIG was that people came to it for CDS, i.e. insurance on these CDOs, and then it couldn't pay out. The problem there wasn't so much the CDOs as AIG was stupid, but a simple clearinghouse with collateral requirements would've ameliorated the issue.) Anyway, allowing me to hedge my purchase of CDOs allows me to offset the risk. That is a legitimate economic and social benefit. How does the Paulson synthetic CDO help with that? Well, it has the same benefits of all speculation, it adds additional money to the system, which helps with pricing and liquidity, and helps to offset risk. More people in the markets means, all things being equal, the market price represents more information.

This is the thing that bugs me. Too many people have formed opinions on this issue with half-baked ideas about finance that they've always had. There's a huge intellectual strain on the Left and indeed a populist strain generally that says Wall Street is one big casino. People are betting on this and that. And in some ways speculators are doing just that. They are making bets on these things. But then again insurance is a bet too. Almost all financial transactions could be called a bet. Shit. My mortgage company bet I'd pay them back. Yes, they could take the house, but they are still betting that I'm gonna pay them back. Moreover, despite all the bad press, speculation isn't necessarily a bad thing.

I understand why people distrust big banks. I'm disgusted by some of their conduct of late. And I'm sure readers of this blog disagree with me about what should be done. That's fine. There are legitimate positions on both side of the speculation is good or bad issue. But for goodness' sake, try to think this stuff through better than the supposedly informed commentators I see on TV and read in the newspaper. Political commentators know fucking jack shit about economics and finance and I never thought I'd be saying this, but I really wish they would shut the fuck up and stick to their politics as a sport coverage of irrelevant minutiae and short-term poll fluctuations.

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