Securing Synthetic Securities
George Soros
May 23, 2010
Project Syndicate
NEW YORK – Goldman Sachs, we can be sure, will vigorously contest the civil suit brought against it by the United States Security and Exchange Commission (SEC). But, regardless of the eventual outcome, the case has far-reaching implications for the financial reform legislation that the US Congress is now considering.
Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security that was derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralized debt obligation (CDO) did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst. The primary purpose of the transaction was to generate fees and commissions.
This is a clear demonstration of how derivatives and synthetic securities were used to create imaginary value out of thin air. Indeed, more triple-A CDOs were created than there were underlying triple-A assets.
This was done on a large scale, despite the fact that all of the parties involved were sophisticated investors. The process continued for years, culminating in a crash that caused wealth destruction amounting to trillions of dollars.
Such activity cannot be allowed to continue. The use of derivatives and other synthetic instruments must be regulated, even if all the parties are sophisticated investors. Ordinary securities must be registered with the SEC before they can be traded. Synthetic securities need to be similarly regulated, although the task could be assigned to a different authority, such as the Commodity Futures Trading Commission.
Derivatives can serve many useful purposes, but they also contain hidden dangers. For instance, they can pile up hidden imbalances in supply or demand, which may suddenly be revealed when a threshold is breached. This is true of so-called “knockout options,” used in currency hedging. It was also true of the portfolio insurance programs that caused the New York Stock Exchange’s Black Monday of October 1987. The subsequent introduction of circuit-breakers tacitly acknowledged that derivatives can cause disruptions, but the proper conclusions were not drawn.
Credit default swaps (CDS) are particularly suspicious instruments. They are supposed to provide insurance against default to bondholders. But, because they are freely tradable, they can be used to mount bear raids – a type of stock market strategy by which a trader (or group of traders) attempts to force down the price of a stock to cover a short position. In addition to insurance, they also provide a license to kill. Their use ought to be confined to those who have an insurable interest in the bonds of a country or company.
It will be the task of regulators to understand derivatives and synthetic securities, and to refuse to allow their creation if they cannot fully evaluate the systemic risks. That task cannot be left to investors, contrary to the diktats of the market fundamentalist dogma that prevailed until recently.
Derivatives traded on exchanges should be registered as a class. Tailor-made derivatives would have to be registered individually, with regulators obliged to understand the risks involved. Registration is laborious and time-consuming, and would discourage the use of over-the-counter derivatives. Tailor-made products could be put together from exchange-traded instruments. This would prevent a recurrence of the abuses that contributed to the 2008 financial crisis.
Requiring derivatives and synthetic securities to be registered would be a simple and effective measure; yet the legislation currently under consideration in the US contains no such requirement. The Senate Agriculture Committee proposes blocking deposit-taking banks from making markets in swaps. This is an excellent proposal that would go a long way in reducing the interconnectedness of markets, thereby preventing financial contagion, but it would not regulate derivatives.
Moreover, the five big banks that serve as market makers and account for more than 95% of over-the-counter transactions in the US are likely to oppose the proposal, because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only plausible explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. Of course, these considerations ought not to influence the legislation.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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With many countries in a balance sheet recession the problem is how to maintain aggregate demand? The deficit hawks have stopped many governments actually doing that. Now they are suffering substantial drops in GDP, as can be seen in the Baltic countries who are following IMF instructions.
ReplyDeleteWorld trade has slumped and with companies actively clearing debts and households doing the same the issue is where will demand come from if no one is buying. Japan had the advantage that the rest of the world was still growing. The US and Europe do not have that advantage now. So the GDP will fall because debts are being cleared and activity is falling. The issue will be more of
It will only recover once the debts have been brought down to manageable levels. Though what would have stopped the problem in the first place is fixed rules on end users debts. It could be as simple as a maximum of 3.5 times a single borrowers income for a mortgage. That would stop the housing bubble getting out of alignment with wages and reduce the fall out when there is a recession. Rules banning loans with higher loan to values of 90% or less even would also help eliminate the risks for banks and lending institutions.
New rules on other lending, and even vanilla products would mean that banking will be less profitable but safer for the state who has to guarantee the financial system.
That fails to answer why do you need Credit Default Swaps? Conventionally if you had an investment that was floundering you had the option of selling it. You may have had to take a loss but the buyer would have the option of holding out for better times.
One downside to the CDS is that it distorts outcomes when insolvency is an issue. Bond holders no longer have an obligation to take a haircut when a company collapses if they own a linked CDS. They will get reimbursed in full only if there is a total failure. That means that what could have been restructured before no longer will get past bond holders who will want 100% payback via a CDS rather than take a haircut via a restructuring. That places bondholders against all other stake holders in a bankruptcy.
Now because of CDS bond holders do not need to trade out of a position. I could understand buying a CDS where the market is very small and illiquid and you do not have an option to sell your holdings but why are government bonds covered by CDS? These are possibly the most liquid of all financial investments. With governments acting as the lender of last resort and backstop to a crisis, it is akin to taking insurance out that an insurer will fail. We have seen how they pervert problems in a company but what if they did the same to a country like Greece or even the US? Maybe they should be banned?