Securing Synthetic Securities

NEW YORK – Goldman Sachs, we can be sure, will vigorously contest the civil suit brought against it by the United States Security and Exchange Commission (SEC). But, regardless of the eventual outcome, the case has far-reaching implications for the financial reform legislation that the US Congress is now considering.

Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security that was derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralized debt obligation (CDO) 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. The primary purpose of the transaction was to generate fees and commissions.

This is a clear demonstration of how derivatives and synthetic securities were used to create imaginary value out of thin air. Indeed, more triple-A CDOs were created than there were underlying triple-A assets.

This was done on a large scale, despite the fact that all of the parties involved were sophisticated investors. The process continued for years, culminating in a crash that caused wealth destruction amounting to trillions of dollars.