Synthetic CDO - Debate and Criticism

Debate and Criticism

The crisis has renewed debate regarding the duty of financial intermediaries or market-makers such as investment banks to their clients. Intermediaries frequently take long or short positions on securities. They will often assume the opposite side of a client’s position to complete a transaction. The intermediary may hold or sell that position to increase, reduce or eliminate its own exposures. It is also typical that those clients taking the long or short positions do not know the identity of the other. The role of the intermediary is widely understood by the sophisticated investors that typically enter into complex transactions like synthetic CDO.

However, when an intermediary is trading on its own account and not merely hedging financial exposures created in its market-maker role, potential conflicts of interest arise. For example, if an investment bank has a significant bet that a particular asset class will decline in value and has taken the short position, does it have a duty to reveal the nature of these bets to clients who are considering taking the long side of the bet? To what extent does a market-maker that also trades on its own account owe a fiduciary responsibility to its customers, if any?

For example, during April 2010 certain Wall Street investment banks and hedge funds were criticized for allegedly creating CDO or synthetic CDO securities designed to favor the short position, without adequately disclosing this to the long investors. The New York Times quoted one expert as saying:

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen...When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

One bank spokesman said that synthetic CDO created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market.

Former Federal Reserve Chairman Paul Volcker has argued that banks should not be allowed to trade on their own accounts, essentially separating proprietary trading and financial intermediation entirely in separate firms, as opposed to separate divisions within firms. His recommendation has been called the Volcker Rule. Proprietary trading can be speculative in nature, while pure financial intermediation would typically involve hedging, with the profit to the intermediary based on fees for arranging transactions only.

Economist Paul Krugman wrote in April 2010 that the creation of synthetic CDO should not be allowed: "What we can say is that the final draft of financial reform...should block the creation of 'synthetic CDOs,' cocktails of credit default swaps that let investors take big bets on assets without actually owning them." Financier George Soros said in June 2009: "CDS are instruments of destruction which ought to be outlawed."

Author Roger Lowenstein wrote in April 2010: "...the collateralized debt obligations...sponsored by most every Wall Street firm...were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house...even when these instruments are used by banks to hedge against potential defaults, they raise a moral hazard. Banks are less likely to scrutinize mortgages and other loans they make if they know they can reduce risk using swaps. The very ease with which derivatives allow each party to 'transfer' risk means that no one party worries as much about its own risk. But, irrespective of who is holding the hot potato when the music stops, the net result is a society with more risk overall." He argued that speculative CDS should be banned and that more capital should be set aside by institutions to support their derivative activity.

Columnist Robert Samuelson wrote in April 2010 that the culture of investment banks has shifted from a focus on the most productive allocation of savings, to a focus on maximizing profit through proprietary trading and arranging casino-like wagers for market participants: "If buyers and sellers can be found, we'll create and trade almost anything, no matter how dubious. Precisely this mind-set justified the packaging of reckless and fraudulent "subprime" mortgages into securities. Hardly anyone examined the worth of the underlying loans."