Dear Friends
and Colleagues: In Friday's Financial Times George reflects on the current case against Goldman Sachs
and the implications more broadly for regulation and reform of the trade of derivatives. I include his essay below. All
best, Michael Vachon George Soros Financial Times, April 23, 2010 The US Security and Exchange Commission's civil
suit against Goldman Sachs will be vigorously contested by the defendant. It is interesting to speculate which side will win;
but we will not know the result for months. Irrespective of the eventual outcome, however, the case has far-reaching implications
for the financial reform legislation Congress is considering.
Whether or not Goldman is guilty, the transaction in question clearly had no social benefit.
It involved a complex synthetic security derived from existing mortgage-backed securities by cloning them into imaginary units
that mimicked the originals. This synthetic collateralised 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. The primary purpose of the transaction was to generate fees and commissions.
This is a clear demonstration of how derivatives and synthetic
securities have been used to create imaginary value out of thin air. More triple A CDOs were created than there were underlying
triple A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors.
The process went on for years and culminated in a crash that caused wealth destruction amounting to trillions of dollars.
It cannot be allowed to continue. The use of derivatives and other synthetic instruments must be regulated even if all the
parties are sophisticated investors. Ordinary securities must be registered with the Securities and Exchange Commission before
they can be traded. Synthetic securities ought to be similarly registered, although the task could be assigned to a different
authority, such as the Commodity Futures Trading Commission.
Derivatives can serve many useful purposes, but they also contain hidden dangers. For instance,
they can pile up hidden imbalances in supply or demand which may suddenly be revealed when a threshold is breached. This is
true of so-called knockout options, used in currency hedging. It was also true of the portfolio insurance programs that caused
the New York Stock Exchange's Black Monday in October 1987. The subsequent introduction of circuit breakers tacitly acknowledged
that derivatives can cause discontinuities, but the proper conclusions were not drawn.
Credit default swaps are particularly suspect. They are supposed to provide insurance
against default to bondholders. But because they are freely tradable, they can be used to mount bear raids; in addition to
insurance they also provide a license to kill. Their use ought to be confined to those who have a insurable interest in the
bonds of a country or company.
It
will be the task of regulators to understand derivatives and synthetic securities and refuse to allow their creation if they
cannot fully evaluate their systemic risks. That task cannot be left to investors, contrary to the diktats of the market fundamentalist
dogma that prevailed until recently.
Derivatives traded on exchanges should be registered as a class. Tailor-made derivatives would have to be registered
individually, with regulators obliged to understand the risks involved. Registration is laborious and time-consuming, and
would discourage the use of over-the-counter derivatives. Tailor-made products could be put together from exchange-traded
instruments. This would prevent a recurrence of the abuses which contributed to the 2008 crash.
Requiring derivatives and synthetic securities to be registered
would be simple and effective; yet the legislation currently under consideration contains no such requirement. The Senate
Agriculture Committee proposes blocking deposit-taking banks from making markets in swaps. This is an excellent proposal which
would go a long way in reducing the interconnectedness of markets and preventing contagion, but it would not regulate derivatives.
The five big banks which serve
as marketmakers and account for over 95 per cent of the US's outstanding over-the-counter transactions are likely to oppose
it because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only
explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. These considerations
ought not to influence the legislation.
The writer is chairman
of Soros Fund Management
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