APRIL 28, 2010.
Is Financial Innovation the Enemy?
Hedging against risk is hardly evidence of misbehavior.
By HOLMAN W. JENKINS, JR
Whether Goldman is bad, very bad or very, very good depends on what business you think it should be in. But its troubles have also brought out the dime-store Jeremiahs declaiming on the perniciousness of "derivatives."
First off, no security is more derivative than a share of stock, which is not really ownership of a company (though it's usually claimed so) but merely a right to whatever cash management deigns to share, plus a right to whatever is left over in a bankruptcy, plus a right to participate in corporate governance in whatever limited ways a company's bylaws permit.
Associated Press A welcome for Goldman Sachs executives at yesterday's Senate hearing.Only an infinitesimal fraction of share sales actually finance something "real." Most are exchanges between one punter and another. Too, any serious person knows that the best guarantee of performance is not a company's bylaws or the SEC, but making sure the CEO owns a large chunk of stock.
By comparison, the Goldman "Abacus" CDO is simplicity itself, despite much malpractice in the press.
The CDO was not "designed to fail." The securities that failed were the simple, wholesome straightforward mortgages that the CDO "referenced," which were designed to extract a fair return from people who supposedly cherished their homes and would strive to pay their bills.
The CDO itself performed exactly as advertised: It paid off the winner of two opposing bets about whether large numbers of mortgage borrowers would default.
Nor was the trade the equivalent of "taking out fire insurance on your neighbor's house," at least in the sense that your intentions were different from what the insurer expected. Instead, it's like you and an insurance company having the following conversation:
You: "I think house X is going to burn down."
Insurance company: "We don't think it will burn down and we know more about houses than you do."
You: "It will burn down."
Insurance company: "Will not."
You and insurance company simultaneously: "Let's bet!"
This is a distortion only in that it underestimates the amount of iteration. The first warning of a housing bubble in The Journal came in August 2001, just weeks after the tech crash. The debate was in full swing by late 2006, when Goldman began putting together the Abacus CDO.
Most gobsmacking, however, is the assertion that such "side bets" serve no legitimate social function.
Come again? With so many financial institutions sitting on massive portfolios of mortgages, how on earth could a mechanism to share some of the risk with willing counterparties fail to be useful? Would that more banks had done so, or that one of those counterparties (AIG) had held up its end more competently.
And how can anyone doubt the utility of John Paulson, after witnessing how vulnerable our individual savings and wealth are to large-scale blunders in the financial system? By engineering the deal, he may have walked away with a disproportionate accretion to his own net worth. For his clients, his timely shorts were probably the difference between losing a lot and losing less in the general crash. If we're going to have a financial system so prone to catastrophic mistakes, we're all going to need a John Paulson.
The disingenuousness is thick with the selective release of Goldman emails by Congressional investigators in advance of yesterday's grilling of Goldman CEO Lloyd Blankfein, the subtext of which was that when Americans see the value of their homes plummet, it's unpatriotic if not criminal not to have lost money along with them. Better than what Mr. Blankfein says now in his defense, though, is the fuller version of what he emailed to colleagues at the time: "Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts. It's not over, so who knows how it will turn out ultimately."
To anyone not in an unseemly haste to join the Goldman whipping detail, this sounds like what every banker should have been thinking at the time: "The future is unknown and scary. Let's hope we're properly hedged."
For the truth is, the "mortgage mess" would likely not have metastasized into a global financial crisis if similar emails were now to be found in the records of Fannie Mae, Freddie Mac, Bear Stearns, Citigroup, Washington Mutual, AIG, Lehman, etc.
Not beyond the wit of man (though apparently beyond the wit of the current Congress) is changing the incentives so housing and other lenders will be less driven or tempted to create "systemic risk." In the meantime, however, all the hooey over Goldman could have genuinely dangerous consequences if it causes Washington to lose the political stomach to backstop the system with its own credit next time a panic threatens a blind run as it did in late 2008.
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