Has Goldman Sachs done something wrong? Do their synthetic collateralized debt obligations pose a systemic risk? If so, what should we do about it?
The courts will decide whether Goldman deceived their customers by withholding or misrepresenting important information to investors they advised. That very important issue aside, we need to put the question of betting in the market in proper perspective. When Goldman, or any other stockbroker, buys or sells company shares on behalf of clients (even if they are the other side of the transaction), the game is considered fair if everyone has access to the same information. Buyers think (are betting) that the share prices will rise and sellers think (are betting) the opposite. One side will win and the other will lose (abstracting from those who are happy to invest their money for a normal return—i.e., share ownership is not generally a zero sum game). This trading activity, some if not much of which is purely speculative (gambling), does not raise capital for the companies whose shares are traded, but the possibility of trading them indirectly lowers the cost of capital when new shares are issued by companies.
Investing in pools of mortgages such as mortgage backed securities is more attractive than investing in individual mortgages because there is greater certainty about the likely default rate of mortgages in the pool than there is about the likely default of any specific mortgage. The same principle of risk pooling applies to other forms of debt as well. Unlike regular collateralized debt obligations (CDOs), synthetic CDOs do not actually own the underlying assets (e.g. mortgages). To simplify, investing in synthetic CDOs (being long) and providing them (being short) is like betting on a stock, bond, or commodity index. Any increase in its price produces a profit for investors and losses for issuers. Any fall in its price produces the opposite result. While this can be and often is pure gambling, it also provides a means of hedging risks. Goldman Sachs issued such instruments (short positions) to reduce large exposures to the mortgage market (long positions) when they became more bearish on that market. If in fact mortgage losses were greater than the market expected at the time, Goldman’s losses on their mortgage exposures would be offset to the extent of their gains on short positions in mortgage assets.
The ethical/legal question in the SECs case against Goldman is whether everyone had the same information about what the index was based on, i.e. which specific mortgages (directly or via Mortgage Backed Securities) were in the pool being bet on. Goldman hired ACA Capital Management to select the “representative” portfolio on which the index would be based. The SEC claims that the hedge fund Paulson & Co, which initiated the creation of the instrument in question (“ABACUS 2007-AC1”) as a vehicle with which it could bet on larger mortgage defaults than was expected by the market at that time, had an undue influence in selecting the mortgages in the pool (ACA claims that it rejected about half of Paulson’s suggestions) and that Goldman did not properly disclose Paulson’s role to other investors. Goldman Sachs claims that it was long in abacus and thus hardly wished to stack the deck against a fair representation of the Subprime mortgage class being bet on (it lost net of commissions $90 million on the instrument when its value declined). In other words, the question here is whether all sides understood what was in the pool (and the contents of Abacus were very complex), i.e., whether the game was fair or not.
Two points are particularly important for the broader issue of regulatory reform to deal with the weaknesses that produced the housing price bubble, its collapse, and the near collapse of the over-leveraged financial sector that finance the bubble. The first is that whatever Goldman Sachs did or didn’t do had nothing to do with the mortgage underwriting standards and/or frequent failure to adhere to them (a different fraud) that subsequently resulted in a much larger rate of mortgage defaults than had been expected or priced into subprime mortgage interest rates. Some mortgages always fail for a variety of individual reasons. The larger than expected losses on subprime mortgages as a group resulted from mortgages being given that should not have been and the inevitable end of the housing price bubble. From there it was just a question of who would be holding the bag when the results were in.
The second point is that those betting for or against these mortgages where consenting adults—they were all big sophisticated investors. They presumably were willing to risk gambling (and losing) the amounts they put at risk. As long as the participants could absorb any potential losses, there would be no nock on (systemic) consequences. If their bets were leveraged with loans from others, the exposure of these other lenders would need to be limited to losses they could safely absorb. However, one of the big losers was a German commercial bank, IKB of Dusseldorf. Commercial banks should not be allowed to take large risks with depositor funds (even if, or perhaps especially if, they are insured). Whether it is best to limit bank risk taking with higher capital charges against such activity or by outright restrictions on what deposit taking banks can invest in (e.g., the Volker plan, only exchange traded, standardized CDSs, etc.) needs careful debate.
Taking these considerations into account, my opinion is that if banks are excluded from the game, the benefits to the capital market of derivatives as hedging instruments outweigh the risks to the system. It is not possible to prohibit the use of such instruments for pure gambling without eliminating their beneficial use for hedging. If bank participation as investors in or producers of such instruments, or in financing others in these activities, are sharply restricted (see “Too big to fail doesn’t cut it anymore”), there is no reason to restrict the creation and marketing of such instruments beyond the honest disclosure of their terms. The case is strong for ring fencing the providers of payment services (narrow banking) and strictly regulating their safety and soundness, while focusing primarily on transparency and honesty for most of the rest of the financial sector. The SEC has a proper role in policing that the game is fair.
Warren Coats retired from the International Monetary Fund in 2003, where he led technical assistance missions to central banks in over twenty countries. He is Senior Monetary Policy Advisor to the Central Banks of Iraq and Afghanistan. His most recent book, “One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina,” was published in November 2007. He has a Ph.D. in economics from the University of Chicago and lives in Bethesda, Md.