Unlocking the code to financial innovation!

I will be the first to admit that I am a CDO ignoramus. After a year of research, I still can't figure out how collateralized debt obligations work or why we need them. What I find mystifying is the opacity of the offering. And from what I understand, we have not only CDOs that we can buy, but synthetic CDOs, which, as far as I can tell, function as a sellable mirage of the original CDO, which is itself a bunch of debt lumped into various tranches of different risk classes.

But apparently we need this kind of innovation - regulations for the financial sector would squash this kind of innovation, so we're told, and then the market for Ferraris would drop significantly.

(JUST KIDDING about those Ferraris!)

In my search for knowledge, I find myself exploring all sorts of econ blogs - enjoying the journey while remaining mystified by the CDO conundrum. So I read with interest the latest post on the Economics of Contempt blog - "On Goldman and synthetic CDOs."

EoC seems a pretty smart guy - he knows far more about the intricacies of finance than I do. He's not shy about expressing his opinion, which makes his blog enjoyable to read.

This post of his is a rebuttal to a post on Yves Smith's Naked Capitalism blog that denounced Goldman's synthetic CDO practices.

You'll have to read both Yves' and EoC's posts to understand the full gist of their debate. Here's what I found so interesting in EoC's post:

"More importantly, what you have to realize — and where I think Yves goes wrong — is that Goldman wasn't necessarily placing an independent bet against the synthetic CDO market; rather, it was using synthetic CDOs to bet against the housing market."

And what, exactly, does it mean when Goldman bets against the US housing market? EoC gives us the formula:

"The mechanism was this: declining housing prices → higher default rates → reduced cash flows to mortgage-backed securities → lower RMBS/CDO prices → higher value of CDS protection on RMBS/CDOs → ca-ching!"

Ferraris for everyone (at Goldman Sachs) when those foolish home owners default on the loans the banks never should have approved.

Now those are some really smart peeps over there at Goldman Sachs. They saw the tsunami coming and made sure they'd ride the wave in a highly profitable manner and not get swamped like Lehman Brothers and Bear Stearns.

(And when they sent Henry Paulson, their CEO, to head up the Treasury Department back in 2006, I guess he didn't much know about this, or he would have done more to prevent the economy from falling off the cliff, rather than wait for it to crash before taking any action.)

EoC knows there is nothing nefarious in Goldman's actions - this is the world of Wall Street - it is inevitable that profit for some means loss for others. Here's EoC's take on this:

"If Goldman's plan all along was for the synthetic CDO market to collapse, then why were they consistently the biggest liquidity provider (by far) in structured products and structured finance CDS (i.e., ABX tranches)? The point is that Goldman didn't need to artificially drive down the synthetic CDO market. They set themselves up to profit from the decline in synthetic CDOs that would follow naturally from weakening fundamentals in the housing market. By the same token, Goldman didn't need to manipulate the structure of the synthetic CDOs they arranged; any run-of-the-mill synthetic CDO referencing subprime-backed cash CDOs (to the extent there was such a thing) would've suffered steep price declines once housing prices started plummeting."

EoC points out that Goldman was public in feeling bearish on housing - and we see now, it was bearish with good reason.

But for me, that code for success (declining housing prices → higher default rates → reduced cash flows to mortgage-backed securities → lower RMBS/CDO prices → higher value of CDS protection on RMBS/CDOs → ca-ching!) is innovation we don't much need today. Betting against the US housing market seems like a terrible way to make a buck. Phenomenally successful for Goldman, but catastrophic for the economy at large.

And so I find myself still mystified at the innovation known as the CDO. Seems like innovation in finance leads us to meander down a rocky trail that takes us from the approval of terrible mortgages to the creation of mortgage-backed securities chock full of those really bad mortgages to higher default rates on those same mortgages to "ca-ching" for Goldman Sachs.

Goldman Sachs saw the collapse of the housing market coming, and its brilliant staff was able to sell synthetic CDOs to customers as they bet those same instruments would lose value.

Those who found themselves with mortgages they couldn't afford and those who bought the innovative financial instruments from firms like Goldman Sachs discovered they owned "the big oops" - products with all loss and no gain.

That's an interesting innovation - creating products that provide an inevitable loss for someone. Hard for me to wrap my head around innovation designed to create massive profit for the innovator when the mortgage default rate goes up as the entire US housing market tanks.

Which leaves me to wonder if modern American financial innovation is designed solely to enrich the sellers of the innovation, with enormous losses in store for consumers of the products.

Here's what Joseph Stiglitz, an Economics Nobel laureate, had to say on financial innovation in a story he wrote for China Daily (an interesting media outlet for Stiglitz's story.)

"Indeed, financial engineering did not create products that would help ordinary citizens manage the simple risk of home ownership - with the consequence that millions have lost their homes, and millions more are likely to do so. Instead, innovation was directed at perfecting the exploitation of those who are less educated, and at circumventing the regulations and accounting standards that were designed to make markets more efficient and stable. As a result, financial markets, which are supposed to manage risk and allocate capital efficiently, created risk and misallocated wildly."

And in the end, the major players in the financial sector, including Goldman Sachs, found themselves on the receiving end of one of the most expansive government entitlement programs ever created. And thus, thanks to innovation that led to a crash that led to a bailout, 2009 was a very, very, very good year for Goldman Sachs.