Friday, April 23, 2010

George Soros on Goldman Sachs & Derivatives

The US Security and Exchange Commission's civil suit against Goldman Sachs will be vigorously contested by the defendant. It is interesting to speculate which side will win; but we will not know the result for months. Irrespective of the eventual outcome, however, the case has far-reaching implications for the financial reform legislation Congress is considering.

Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralized debt obligation 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 have been used to create imaginary value out of thin air. More triple A CDOs were created than there were underlying triple A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors. The process went on for years and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It 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 Securities and Exchange Commission before they can be traded. Synthetic securities ought to be similarly registered, 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 in October 1987. The subsequent introduction of circuit breakers tacitly acknowledged that derivatives can cause discontinuities, but the proper conclusions were not drawn.

Credit default swaps are particularly suspect. They are supposed to provide insurance against default to bondholders. But because they are freely tradable, they can be used to mount bear raids; in addition to insurance they also provide a license to kill. Their use ought to be confined to those who have a insurable interest in the bonds of a country or company.

It will be the task of regulators to understand derivatives and synthetic securities and refuse to allow their creation if they cannot fully evaluate their 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 which contributed to the 2008 crash.

Requiring derivatives and synthetic securities to be registered would be simple and effective; yet the legislation currently under consideration contains no such requirement. The Senate Agriculture Committee proposes blocking deposit-taking banks from making markets in swaps. This is an excellent proposal which would go a long way in reducing the interconnectedness of markets and preventing contagion, but it would not regulate derivatives.

The five big banks which serve as marketmakers and account for over 95 per cent of the US's outstanding over-the-counter transactions are likely to oppose it because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. These considerations ought not to influence the legislation.


  1. I hate how the investment companies like Goldman Sachs are allowed to create this fake kind of business all in the name of greed.
    While I read your post I was impressed with your understanding of these instruments of trading,but another thought came to my mind,does the average Joe and Jane Lunchbucket understand how these instruments affected them?
    As long as people like Tim Gaithner and Larry Summers have any say in the economics of this country,Goldman Sachs will not be found guilty of anything,at most they will get a public scolding.

  2. And so many more provisions which are needed but will never be included as law (in our still Government Sachs-ruled country).

    Thanks for this exposure!


    Requiring derivatives and synthetic securities to be registered would be simple and effective; yet the legislation currently under consideration contains no such requirement.

  3. This is so complicated. I can almost see why the'd rather watch porn than deal with it.

  4. The Blanche Lincoln deal in the Agricultural Senate bill is what Soros refers to, and he's right. It would be sorta like the Volcker Rule or Glass-Steagall cause it would separate commercial banking activity (take deposits/make loans) from investment activity-in this case dealing in derivatives.

    Since commercial banks get the benefit of FDIC backing for their deposits plus discounted loans from the Fed, if they engage in risky activity and that risk blows up taxpayers will be left holding the bag. So separating investment high risk activity from depository activity is a much needed regulatory step.

  5. Oso, Big Mac & Suzan seem to have a good command of financial reform issues. But I'm more in Will Hart's camp: economics was not my strongest suit in college and grad school.

    But I heard Robert Reich on NPR a couple of days ago. He laid it out persuasively in three points. As soon as I saw Proxy's post, I determined to look Reich up on the Web. Reich's three minimal points (currently omitted from Dodd bill) are:

    1. Require that trading of all derivatives be done on open exchanges where parties have to disclose what they’re buying and selling and have enough capital to pay up if their bets go wrong. The exception in the current bill for so-called “unique” derivatives opens up a loophole big enough for bankers to drive their Ferrari’s through.

    2. Resurrect the Glass-Steagall Act in its entirety so commercial banks are separated from investment banks. The current bill doesn’t go nearly far enough. Commercial banks should take deposits and lend money. Investment banks should be limited to the casino we call the stock market, helping companies issue new issues and making bets. Nothing good comes of mixing the two. We learned this after the Great Crash of 1929, and then forgot it in 1999 when Congress allowed financial supermarkets to do both.

    3. Cap the size of big banks at $100 billion in assets. The current bill doesn’t limit the size of banks at all. It creates a process for winding down the operations of any bank that gets into trouble. But if several big banks are threatened, as they were when the housing bubble burst, their failure would pose a risk to the whole financial system, and Congress and the Fed would surely have to bail them out. The only way to ensure no bank is too big to fail is to make sure no bank is too big, period. Nobody has been able to show any scale efficiencies over $100 billion in assets, so that should be the limit.

    Reich finishes by calling for all denizens of "Main Street — Tea Partiers, Coffee partiers, and beer drinkers — to be heard".

  6. Vig,
    Sadly, Will was a victim of a subprime scam run by Suzan and myself. We sold poor Will the "Contra O'Reilly" blog then using derivatives bet that it would fail.

    However we did nothing illegal and we regret any inconvenience our efforts caused.

  7. Robert Reich is great. If reform could be summed up in three parts that would certainly do the trick.

  8. I can't seem to STFU.
    We need financial reform desperately, perhaps even more desperately we need INCREASED govt spending,fiscal stimulus, to fund Demand since the private sector is saving and paying down debt. Attempting to cut spending/balance the budget (since the private sector isn't spending) will force the economy down, the gap between the optimum amount of production of goods/services and the actual amount will decrease even further, forcing the economy down and an even deeper recession. essentially the US economy, combined private/govt sector is double entry bookeeping on a nationwide scale.govt deficit means private surplus and vice versa.

    So what scares me is-unless the president openly talks about the need to spend, rather than agreeing with the idiot deficit hawks-whatever financial reform package passes whether it's good or bad, the Republicans will blame the dip back into recession on the bill, rather than blaming the real cause-cutting spending. They will blame the solution, rather than the cause which is them.

  9. I am presently in litigation with Fremont Reorganizing, Goldman Sachs dba Litton Loan Servicing, et al., (2 different cases) for about 2 years now. The main issue with the complaint is a fraudulent loan originated by Fremont in June 2006. This in turn produced an array of other
    issues: unsigned deed of trust, over billing issues, lost payments, excessive balloon payment, back dated assignments, illegal non-judicial foreclosure documentation, missing documentation, illegally reporting to my credit, falsifying declarations, 6 week TRO's, court procedures not followed, judges wait until the courtroom is cleared to rule against a TRO (both times); retired (78 year old) judge ruled against a seated judges TRO where the retired judge took 30 minutes to read a 300 page brief. The whole time they have been ignoring my request and failing to give me the required documentation so that I can rescind the loan. Goldman Sachs dba Litton Loan Servicing has been aggressively trying to foreclose on my property. I believe to cash out for insurance reasons. (It's over a million dollar loan) I have invested over $400,000 into this property for the past 5 years and if I had known about this mortgage meltdown game played by Wall Street I would have never proceeded with this Real Estate transaction. The Media and the Government has not once addressed or helped the borrower, namely me, who also has been damaged by these defaulted CDO's.

    A Time line of what's going on with Goldman Sachs to show how they are scheming to pursue foreclosures for the insurance by acquiring distressed, shelled fraudulent companies which will eventually or haven't already gone BK...

     Oct 26, 2005 Litton Loan Servicing Class Action - mishandling loans, servicing over 400,000 borrowers - case settled Feb 17, 2009 for $537 (limited due to class status)
     Feb 27, 2007 FDIC Cease and Desist - Fremont Reorganizing for illegal loan practices, et al., (largest predatory lenders who heavily solicited brokers for their schemes)
     Oct 16, 2007 Massachusetts Lawsuit vs Fremont and Goldman Sachs - Predatory Lending Practices - settled May 11, 2009 for $60 mil
     Dec 11, 2007 - Goldman Sachs Acquires Litton Loan Servicing
     June 2, 2008 Litton (Goldman Sachs) Acquires Fremont Reorganizing Servicing Rights
     June 19, 2008 Fremont Reorganizing files BK
     Apr 16, 2010 - SEC vs Goldman Sachs - Securities Fraud

    Here is the link to my blog if you want to download court documents pertaining to my case.

    Note: My wife is pursuing individuals who are interested in joining her in a class action lawsuit with regards to violation of her community property rights in a wrongful foreclosure. If you are in a community property state and a spouse is not on title you may have grounds for legal action.

  10. I knew I should have read that fine print. Damn it, where's Michael Milken when you really need him.

  11. Good luck with your case, About-Us!

  12. Oso, I'd be willing to buy shares in what's left over from CONTRA O'REILLY INC. but who do I go to? You, Suzan, or Will?

  13. Michele Bachmann recently stated that our government is run by gangsters. Sorry, Michele: wrong again (for the umpteenth time). Our government, and our economy, too, has been run by BANKSTERS for a very long time. And a bankster makes a gangster look like a Boy Scout. It will indeed be very interesting to see how Goldman-Sachs wiggles out of this little jam!

  14. I don't think it will be an interesting drama, Jack. I would characterize it as tragic. Another test of the Obama administration who has another cliche of corporate criminals where we all want them. If the banksters wiggle out of their poster-boy jam, it will be more evidence that the Obama administration is only liberal and not Progressive.