A Proposal for Reform: No More Managed Money in the Synthetic Derivatives Market

Synthetic derivatives are having their 15 minutes of fame. It began with the SEC's lawsuit against Goldman Sachs, which featured the world's best known synthetic CDO, ABACUS 2007-AC1. Goldman allegedly structured this deal in a way that favored the short side investor, John Paulson & Co., without telling the long side investors about Paulson's involvment in choosing the collateral. Now, the financial press reports that Morgan Stanley is under SEC investigation for creating synthetic CDOs called "Baldwin" and "ABSpoke" in a way that supposedly favored the short side, and then itself investing in the short side. If the reports about Morgan Stanley are true, its conduct would arguably be worse than Goldman's, which did not include a proprietary bet against its long side customers. Other major Wall Street banks are also reportedly under investigation for structuring similar transactions and then taking the short side.

Enough already. Synthetic CDOs are pure bets, like sports bets. Unlike "real" CDOs, which can be connected to substantive economic activity, synthetic CDOs have no socially redeeming value. Yet, they can cause billions of dollars of losses. One solution would be to ban them outright. However, investors might simply go to offshore markets, where transactions would be even less visible and regulated than they are now.

A better idea would be to protect the money we really care about: managed money. Institutions holding or investing money for others shouldn't be allowed to transact or invest in synthetic CDOs or other synthetic derivatives. That would include broker-dealers, mutual funds, pension funds, banks and credit unions, insurance companies, investment advisers, trust companies and other fiduciaries, financial advisers who manage funds for clients, and anyone else who holds or invests money for others. The prohibition would not only apply to direct transactions and investments in synthetic derivatives, but also indirect transactions and investments through parent corporations, subsidiaries or other affiliates or agents. We wouldn't allow money managers to book or invest in sports bets. Why let them bet or make book in synthetic derivatives, which are analytically indistinguishable from sports bets? One advantage of taking the managed money approach is that the prohibition would extend to offshore markets as well as the U.S. market.

An exception could be made for independent hedge funds and other independent entities that receive no government subsidies, bailouts, or benefits (like deposit insurance) and whose investors are limited to individuals meeting the definition of accredited investors (i.e., those with net worths of $1 million or more, or who make more than $200,000 a year ($300,000 for married couples)) and institutions that aren't themselves prohibited from transacting or investing in synthetic derivatives (remember, no indirect transacting or investing). That would amount to a rather small universe of gamblers, but the point is to protect managed money.

Of course, Wall Street would howl in protest over such a proposal, as the lost profits could seriously impact bonuses. Tant pis, as the French would put it. Whatever Goldman Sachs and other big banks might say about their conduct not being illegal, none of them have made a coherent case why synthetic derivatives are good or socially beneficial. Only the most money-obsessed parents would want their children to grow up to sell synthetic derivatives. Plenty of derivatives contracts have made the trek to Boot Hill (such as the once popular portfolio insurance). The synthetic derivative has had plenty of opportunity to demonstrate its value to society, and has failed abysmally. R.I.P.