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Thursday, April 22, 2010

Synthetic CDOs and Goldman Sachs

The latest Goldman Sachs scandal involved a synthetic CDO (Collateralized Debt Obligation). That's a type of complicated derivative that treats the market like a casino.

For a regular CDO, the buyer partially owns the mortgages in the CDO. The interest payments come from mortgage repayments. For a synthetic CDO, you're betting on mortgages actually owned by someone else. The only way you can buy a synthetic CDO is if someone else is willing to short sell it. Any profits by one side are exactly matched by losses on the other side.

Here's another example. For a single-stock option, you take actual delivery of the stock when exercising. For index options, you only get cash based on the index price. The index option is another synthetic derivative. You're getting paid based on something you don't own.

For most financial derivatives, gains by one party exactly equal losses by another party. A synthetic CDO or credit default swap is a pure bet; one party's gain is the other's loss.

Sometimes, there are different interest rates for different parties. An airline wants to hedge its fuel expense. The airline would have to borrow at 6%, while a bank borrows at the Fed Funds Rate. The airline buys an oil future/derivative from a bank. The bank borrows newly printed money from the Federal Reserve to finance the transaction. In that case, the cost is paid by the rest of society via inflation. Both the airline and bank profit from that trade, but everyone else experiences inflation.

Most of the time, inflation and negative real interest rates feed derivative transactions. The derivatives market didn't explode until after the gold standard was fully abandoned in 1971. With a gold standard, interest rates can't fall below 0%, limiting financial industry shenanigans and derivatives. Negative real interest rates are a key component of most derivative transactions. It's pure parasitism.

Why would anyone buy a sythetic CDO? Due to the Federal Reserve credit monopoly, interest rates are less than true inflation. This forces people to chase higher returns, just to keep pace with inflation.

If money market rates are 4% and the CDO pays 4.5%, then you'll buy the CDO. The CDO is marketed as a super-safe investment. If the synthetic CDO pays 4.7%, then you'll buy the synthetic CDO instead of the regular CDO.

Goldman Sachs said that the synthetic CDO was a good investment. In fact, the bonds in the synthetic CDO were cherry-picked so that the CDO would do poorly. That's the basis of the fraud case.

Whoever bought the synthetic CDO probably was stupid. They should have realized that the only way to buy a synthetic CDO is if someone else is willing to short sell it. A slightly higher return shouldn't entice you, because that always comes with higher risk.

A non-free market forces people into lousy investment choices. One criticism is "Insiders have an advantage. They know the details of the CDO, but the customers do not." In a really free market, nobody would ever accept such an obviously unfair arrangement. The banks act as a cartel. If you don't want to get ripped off by inflation, you have to invest. Inflation is a tax on people holding cash, forcing people to invest. For most investment products (other than physical gold or silver), there are hefty commissions (explicit and indirect) earned by the financial industry. For example, a money market investment has an hidden tax, the difference between the interest rate and true inflation. The money market investment seems safe, but it's really the riskiest investment due to the guaranteed loss to inflation.

The Federal Reserve credit monopoly gives the banksters an unfair advantage over everyone else. If a bankster wants to finance a mortgage, he borrows at the Fed Funds Rate (currently 0.25%) and buys a mortgage yielding approximately 5%. With high leverage, this is a very lucrative trade. If I want to finance mortgages, I don't get to borrow at the Fed Funds Rate. The return of 5% is insufficient compensation for inflation. The Federal Reserve credit monopoly gives insiders a monopoly for financing mortgages and businesses.

It's silly to talk about financial industry reform without also discussing the immoral Federal Reserve credit monopoly. The actual "reform" proposals are probably a type of corporate welfare. The cost of complying with the new regulations will cost small banks a larger % of their profit than large banks. More regulation usually makes things worse. The real problem with the financial industry is the Federal Reserve credit monopoly. There also are laws and taxes that make competing monetary systems illegal.

Goldman Sachs' abuse of synthetic CDOs is a symptom of a bigger problem. The USA does not have a free market banking system. State control of money and inflation affect all economic activity. Via a corrupt monetary system, State parasites profit at the expense of productive workers. Via inflation and taxes, State parasites get a cut of all on-the-books productive economic activity.

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