Cheryl Smith, Ph.D., CFA, President
In the mind-numbingly complicated world of 21st century high finance, it’s not always obvious which transactions are unethical versus those which are, if not high-minded, at least legally permissible within a deeply flawed system.
The Securities and Exchange Commission (SEC) has charged Goldman Sachs with fraud in connection with the creation and sale of a “synthetic synthetic Collateralized Debt Obligation” (SSCDO) allegedly custom designed to allow a favored client, John Paulson, to place a outsized bearish bet against the mortgage market. The alleged fraud is not in the creation of the security but in the lack of transparency and disclosure provided to other investors in the security.
An SSCDO, as the name hints, is many steps removed from any underlying asset. The one in question was created by establishing a “reference” portfolio of mortgages whose behavior was tracked as the basis for the payouts of the SSCDO. The important point is that neither the seller nor the investors of the SSCDO own either the underlying assets or insurance on the underlying assets, so they are not in any sense hedging a risk or their own position.
The allegation is that Goldman, by failing to adequately disclose, served as middleman in a con – that they deliberately constructed a security to the hidden specifications of one client, and then represented that it was constructed by an independent party to have certain expected risk and return characteristics, while it actually was constructed to only have the surface appearance of those characteristics and a strong probability that it would behave differently.
Is it permissible under the regulatory regime to do this? The courts will ultimately decide this question. But what Goldman did by selling its own clients down the river to benefit a favored client is clearly unethical. Greater transparency and disclosure of Paulson’s role in the creation of the portfolio would have improved both the ethics of the transaction and its conformance with regulations.
The grand conclusion that we need better transparency and disclosure isn’t exactly earth-shattering, and I’m not convinced that current proposals to trade derivatives on exchanges address the underlying deficiencies of this transaction. (Do we need a regulation that “Thou shalt not defraud one group of less-favored clients on behalf of another, more favored client?”)
The bigger question, leaving disclosure aside, is whether so-called investors should be allowed to gamble by creating a financial superstructure with no economic interest in the underlying activity. This is not hedging; this is not laying off risk; this is not serving to gather liquidity to finance underlying production. This is speculation, and I fail to see the social or economic benefit. While there may be some benefits from synthetic finance, they are far outweighed by the larger social costs – increased volatility, misaligned incentives, and opacity leading to fraud, waste and abuse. These types of assets easily generate a kind of financial pollution, an economic toxic waste, and our current regulatory structure does not make it sufficiently costly to discourage their production. As long as gaming the regulatory system continues to be enormously profitable, devising an effective regulatory structure will be a Sisyphean task.
Eventually, to reduce the role of speculation, you just have to do what is right. As shareholders and as participants in an economy threatened by financial toxic waste, we have our work cut out for us. So does Goldman Sachs. And until we’re convinced it can recognize and reject an immoral or unethical undertaking of huge consequence, we won’t be invested in the stock any longer.
Cheryl Smith, Ph.D., CFA, President