THE MISGUIDED ATTACK ON DERIVATIVES / THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

OPINION: INFORMATION AGE

APRIL 26, 2010.

The Misguided Attack on Derivatives

Short-selling warns markets that an asset bubble is about to burst.

By L. GORDON CROVITZ.

After years of finger pointing for the housing bubble and credit crisis, from Washington to Wall Street and back, the upshot is this: a Securities and Exchange Commission complaint targeting one of the few people who realized the mortgage market would implode.

This is the surprising significance of the high-profile and complex complaint the agency filed earlier this month against Goldman Sachs for its work with hedge-fund trader John Paulson. The investment bank crafted securities that let him put his money where his analysis was, pointing to the housing boom as unsustainable.

One of the frequently asked questions about the housing bubble is why no one saw the problem until it blew up. The answer is that a few people did. Mr. Paulson, who was not charged in the SEC lawsuit, is chief among them.

Beginning in 2006, Mr. Paulson concluded that the end of the bubble was near. Goldman Sachs created special securities to facilitate trading, in this case synthetic collateralized debt obligations—synthetic because this instrument didn't include mortgage-backed securities but was designed to move in line with them. Mr. Paulson thus communicated his wisdom to the market through these securities, which, far from undermining markets are best understood as an efficient information medium for resetting prices.

By analyzing the low quality of mortgages, he saw early the combination of easy money by the Federal Reserve, easy mortgages mandated by Congress, and what turned out to be too-easy math by Wall Street traders who failed to realize that this rare combination of factors would undermine their risk models. "It is easy to forget that before the collapse, the overwhelming view of investors, ratings agencies and economists was that the housing market was strong and would continue to get stronger," Mr. Paulson told his investors last week. He warned them in 2006 that he would start risking their money by shorting what he thought were bad mortgages.

Mr. Paulson needed some kind of investment vehicle to put his painstaking housing analysis into action. He was especially interested in betting that subprime mortgages would go bad in places like California, Arizona and Florida. Sophisticated institutions such as ACA Capital, IKB Deutsche Industrie bank and Goldman Sachs itself took the other side of the derivative. These firms still hoped that happy housing days were forever. The result was that the banks lost about $1 billion, Mr. Paulson and his investors made $1 billion, and people felt the first tremors of the housing market crashing down.

There was no secret about why these securities were created. "All our dealings were through arm's-length transactions with experienced counterparties who had opposing views based on all available information at the time," a spokesman for Mr. Paulson said last week. "We were straightforward in our dislike of these securities, but the vast majority of the people in the market thought we were dead wrong and openly and aggressively purchased the securities we were selling."

The SEC's complaint is that Goldman Sachs should have disclosed Mr. Paulson's role in suggesting what to include in this new security. This is a novel interpretation of the obligations under the securities laws, which is probably one reason the SEC commissioners split on party lines about whether to file the lawsuit. Long buyers in these specially created securities knew someone else was selling short, but it would be hard to prove that it mattered who it was.

Whether the SEC's complaint succeeds or not, it has piled on to the image of derivatives as dangerous instruments of no social good. The financial reform bill making its way through Congress puts tight restrictions on derivatives. But consider a derivative simply as a way for someone to warn, through trading, that he has information about a shift in a market.

Reducing the opportunity for traders to take advantage of better information means slowing the pace at which better information enters the market. Do we really want the next bubble to continue even longer before it bursts? Derivatives are more important as a way to trade on information about housing than about many other markets, because houses are not as liquid as, say, shares in companies.

Easy money, easy mortgages, and banks too big to fail were key causes of the credit crisis. It was also Wall Street's greatest information failure in many years. We need more trading, not less, and more signals in the market faster that prices need to be adjusted. The last thing we need is outlawing opportunities for people like Mr. Paulson to bring vital information to market.

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