Casino Gambling on Wall Street
Case 4.5 Casino Gambling on Wall Street
CDO stands for “ collateralized debt obligation,” and before the financial meltdown of 2008, hardly any nonspecialists were familiar with this arcane acronym. A CDO is a collection of individual debts ( for example, home mortgages) that are bundled together in one investment pool. That pool can then be divided into different sections ( or “ tranches”), representing different degrees of risk, and sold to investors. An individual lender, such as a credit card company, may put together a CDO, or an investment firm may create a CDO from a package of loans from different lenders. Although abused during the housing bubble, CDOs perform a useful economic function. They allow lenders to focus on loan origi-nation and investors to buy interest- earning securities. 86 What serves no obvious economic function, however, are so- called synthetic CDOs, which represent a bet on the of a package of loans owned by others. For exam-ple, Goldman Sachs brokered a synthetic CDO, known as Abacus- 2007 AC1, based on the performance of a group of subprime loans. But unlike a normal CDO, a synthetic like Abacus contains no actual bonds or mortgage loans; it merely references assets owned by other people. As with other synthetic CDOs, one side of the option was betting the value of a bundle of assets ( owned by other people) would rise; the other side of the option that it would fall. In principle, it’s no different from wager-ing on the Yankees vs. the Dodgers or on a cricket fight. “ With a synthetic CDO, it’s a pure bet,” says Erik F. Gering, a former secu-rities lawyer and now a law professor at the University of New Mexico. “ It is hard to see what the social value is.” In the two years before the financial meltdown of 2008, over $ 100 billion in synthetic CDOs were issued, and everyone agrees that, by increasing the instability of the system, they were an important factor in that crisis. Moreover, their use represents a shift in the culture of investment banks from a focus on finding the most produc-tive allocation of savings to an emphasis on maximizing profit through proprietary trading and arranging casino- like wagers for market participants. For these reasons, many business writers and financial experts are critical of syn-thetic CDOs and other purely speculative derivatives, believing that they should be severely limited or even pro-hibited. However, companies like Goldman Sachs and oth-ers make $ 20 billion a year putting them together, and these firms lobbied strongly and successfully to see that the financial reform bill of 2010 didn’t significantly restrict them. In their defense, one industry insider says, “ I believe that synthetic CDOs have a very useful purpose in facilitat-ing the management of risk. . . . Such instruments facilitate the flow of capital.” But it is difficult for even the heartiest champion of syn-thetic CDOs to defend the Abacus- 2007 AC1 deal with a straight face. Goldman Sachs put it together for hedge fund tycoon John Paulson based on a group of lousy mortgage loans that he had selected for the sole purpose of betting that their value would go down. As with any synthetic CDO, of course, Goldman Sachs needed to find investors who would take the opposite position, which it did— the two largest being ABN Amro and IKB Deutsche Industriebank— and it was paid $ 15 million for closing the deal. Those companies, however, were not told that Paulson was betting against them nor that he had selected the underlying subprime mortgages only because he believed they were sure to lose value. And, sure enough, Abacus- 2007 AC1 soon produced a $ 1.5 bil-lion loss for ABN and an $ 840 million loss for IKB— but a $ 1 billion gain for Paulson. Goldman Sachs’s defenders say that ABN and IKB were sophisticated investors who should have known what they were doing and that who is on the other side of a CDO is not something that is routinely disclosed. So perhaps ABN and IKB deserved what they got— after all, one might argue, they had no real business undertaking a synthetic CDO as opposed to underwriting or insuring actual subprime loans. But, still, it’s hard to square Goldman Sachs’s treatment of them with the principle displayed on the company’s website: “ Our client’s interests always come first.” Goldman Sachs, of course, is not the only financial institution to manipulate its customers. The Securities and Exchange Commission has accused Citigroup, for exam-ple, of putting together a package of mortgage backed securities without telling investors that it was betting against them— that the fund was designed to fail. When it did, Citi earned $ 160 million while its investors lost $ 700 million. On the other hand, spread across the country are thousands of small community banks and not- for- profit credit unions. Believing that their job is to serve the com-munity, they often take a personal interest in their cus-tomers, making loans to local businesses, lending small sums to individuals who have fallen into financial trouble, or bending over backwards to help those who can’t keep up their mortgage payments. “ They support you person-ally,” says one customer. “ Customers . . . can walk in and talk to the president,” adds another, “ and know he isn’t sucking in their money and betting against them on pro-prietary securities.”
1. Are synthetic CDOs a legitimate business investment, or are they pure gambling? If the former, what are their benefits? If the latter, should banks and other companies be allowed to wager on whatever they want if they like the odds and think they can make money that way?
2. In your view, what does the rise of synthetic CDOs tell us about contemporary capitalism?
3. Should synthetic CDOs be regulated in some way or even banned altogether?
4. Should Goldman Sachs have disclosed Paulson’s role to IKB and ABN? In not doing so, did it act immorally? What obligations, effects, and ideals are relevant to answering these questions?
5. Did John Paulson do anything wrong? Explain why or why not.
6. As the top banks continue to get larger and larger, can small, community- oriented banks survive? Contrast the models of capitalism represented by the two types of banks. Where do you bank?
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