'Naked' Derivatives: Speculative Bets With No Higher Purpose

As public outrage mounts over Wall Street's role in fostering the financial crisis, a heated exchange about whether powerhouse investment bank Goldman Sachs (GS) profited by betting against the housing sector is the latest fuel to be thrown on the fire. And despite the firm's hair-splitting legal defense, many observers feel Goldman could be in legal trouble, according to some polls.

The most striking portrait to emerge from the fraud charges, though, may be that of the sheer uselessness of much of Wall Street's activities in recent years. The financial sector's share of domestic corporate profits, after all, has ballooned to 41% from just 16% during the mid-1980s. But the industry's focus on channeling capital to productive uses through investment has been increasingly swapped for orchestrating elaborate bets with only a modest base in the real world.

At the heart of recent calamitous wizardry, and the Goldman Sachs fraud case in particular, lie instruments like synthetic collateralized debt obligations (CDOs), an abstraction of securities based on a "reference portfolio" that can contain derivatives based on the underlying securities and insurance-like instruments called credit default swaps (CDSs). The use of "naked CDSs," so-called because they're purely speculative bets by parties that don't hold any of the actual underlying securities being "insured," have been particularly disastrous.

Listen to George Soros

The investment world has always been inherently speculative, of course. But many of the instruments that were part of the massive expansion of the financial sector in recent decades have, like naked CDOs, been purely speculative and sidestepped any constructive investment purpose entirely.

And don't get fooled into thinking it's only obscure anti-financial zealots who have been most disturbed by this trend. Billionaire investor George Soros, among the most successful and high-profile hedge fund managers ever, has been the most vigorous in sounding the alarm about uselessness of these instruments.

"Whether or not Goldman is guilty, the transaction in question clearly had no social benefit," Soros wrote last week. "It involved a complex synthetic security that was derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals."

And "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," he pointed out. So why did Goldman go through the trouble of creating Abacus? Says Soros: "The primary purpose of the transaction was to generate fees and commissions."

"Limited Profits but Almost Unlimited Risk"

Indeed, even frequently maligned financial activities like short-selling -- where an investor sells a borrowed security with the intent of replacing it later at a lower price and pocketing the difference -- serve an indispensable purpose in the financial markets. Short-sellers have incentives to unearth negative information about a company, cut through the hype and ultimately lead to sounder investments by fostering price discovery. Short-sellers who exposed the fraud at Enron even as that company was otherwise extolled was a vivid demonstration of the technique's value.

Moreover, short-selling is a dangerous game because being wrong exposes the short-seller to growing and potentially vast risks. As a result, short-sellers have to be even more judicious than their long counterparts.

A naked CDS, on the other hand, provides exactly the opposite set of incentives and encourages recklessness. "Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential," Soros wrote about the destabilizing, often self-fulfilling dynamic. "By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds." Just ask AIG about that "practically unlimited risk."

Why Even Do an Abacus?

In pushing to have most derivative deals traded on exchanges where they can be better regulated, financial reform regulation currently being considered takes a step in the right direction. But those measures don't go far enough. Taking out insurance on bonds not owned through naked CDSs serves to amplify risks rather than hedge them and should be banned, for example.

This week's Senate hearings that Goldman CEO Lloyd Blankfein and former Vice President Fabrice Tourre are scheduled to testify at are sure to be packed full of questions about what exactly Goldman's clients knew about the Abacus deal and when they knew it. A more important question, though, is why such a transaction was brokered in the first place.

If Wall Street is ever going to regain some trust from individual investors, it needs to go back to the undoubtedly risky business of investing -- rather than merely placing dangerous high-stakes bets.