The SEC-Goldman Flap
By Arnold Kling
A CDO, synthetic or otherwise, is a newly formed investment company. Typically there is no identifiable “seller”. The investment company takes positions with an intermediary, which then hedges its exposure in transactions with a variety of counterparties. The fact that there was a “seller” in this case, and his role in “sponsoring” the deal, are precisely what ought to have been disclosed. Investors would have been surprised by the information, and shocked to learn that this speculative short had helped determine the composition of the structure’s assets. That information would not only have been material, it would have been fatal to the deal, because the CDO’s investors did not view themselves as speculators.
This stuff is getting beyond my depth. I’m guessing that a synthetic CDO is to a CDO as a fantasy baseball team is to a baseball team.
My fantasy AL baseball team this year includes Taylor Teagarden (0 for 18 so far this year), David Murphy (1 for 14), Brandon Wood (4 for 40), Milton Bradley (7 for 42), and Brendan Harris (4 for 19). No, John Paulson did not pick my team so that he could short it, although it probably looks that way.
My sense is that Waldman is overstating the case when he says that a synthetic CDO is a security. Suppose that we created a synthetic mutual fund that did not actually own stocks. I don’t think that synthetic mutual fund would be a security. But, again, I am probably beyond my depth.
To me, the compelling points are the following:
1. Nothing could happen to the synthetic CDO until the prices of the underlying mortgage securities changed. At the moment that the synthetic CDO is formed, the prices of the mortgage securities presumably reflect all available information. If they are lousy mortgage securities, that fact is already represented in the price. Even if I am totally ignorant about the underlying mortgage securities, as long as they are appropriately priced at the time the synthetic CDO is formed, as an investor I have a fair shot at making a profit. Even if a short seller selects the securities, he can only select them for his view of their potential to fall, and he may or may not be correct about that.
2. The investors in these securities were professional money managers. Yes, they managed the money that belonged to other people, and those other people may have included widows and orphans, but John Paulson was managing other people’s money, also. The reason that the professional money managers lost money on synthetic CDO’s is not that Paulson picked the securities in the CDO. It is that the professional money managers took a view of future developements in the mortgage market, and they were wrong. Just as I took a view of the prospects of Teagarden, Murphy, and others, and I was wrong.
Megan McArdle implies that the decision to pursue the case against Goldman was not unanimous at the SEC, and that it was made along party lines. Sebastian Mallaby, who is a pretty straight shooter, also sees the case as more political than not.
To me, the government’s case seems pretty artificial. The main reason that investors in synthetic CDO’s lost money is that they took the wrong view of the mortgage market. That does not entitle them to intervention by the SEC, as I see it.