Corporate & Securities Law

Bringing Down The Financial House: Synthetic CDOs

By Steven Caruso

Synthetic collateralized debt obligations, or CDOs, are complex mortgage-linked debt products that have been blamed for bringing Wall Street to its knees and pummeling millions of investors in the process. It was in the fall of 2007, when the financial markets first started to become unhinged, that these high-risk instruments found their way into the public?s eye.

Today, CDOs are a hot topic on Capitol Hill, where members of Congress and regulators like the Securities and Exchange Commission (SEC) are trying to determine exactly how and why synthetic CDOs created the financial tsunami that they did.

As reported Dec. 24 in an article by Gretchen Morgenson and Louise Story for the New York Times, regulators are said to be looking at whether current securities laws or rules of fair dealing were violated by the investment firms and banks that created and sold CDOs and then turned around to bet against clients who purchased them.

?One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded,? the article says.

Pension funds and insurance companies are some of the institutional investors that lost billions of dollars on synthetic CDOs - investments they thought were safe investments.

The New York Times article devotes space mainly to the synthetic collateralized debt obligation business of Goldman Sachs and, specifically, mortgage-related securities called Abacus synthetic CDOs. Abacus CDOs were developed by Goldman trader Jonathan Egol, who had the idea that they would protect Goldman from investment losses if the housing market ever collapsed.

According to the article, when the market did tank, Goldman created even more of these securities, enabling it to pocket huge profits. Meanwhile, clients of Goldman who purchased the CDOs - and who thought they were solid investments - lost big.

One can easily infer from the article and other news reports on the subject that Goldman put the best interests of clients in harm?s way with Abacus because it not only served as the structurer of the deals involving the product, but also held onto the short side of those same deals. In other words, the company would be advising clients to buy assets that, in turn, it was betting to fail.

Goldman certainly is not the only investment firm that employed this strategy. Others banks created similar securities that they sold to clients and then bet against the future performance of those assets.

Goldman and other investment banks will soon have to answer tough questions about accountability and fiduciary duty. In the meetings being held on Capitol Hill, the Financial Crisis Inquiry Commission - a group that has been compared to the 9/11 Commission - plans to call several panels of investment banks to appear as witnesses. Among them: CEOs of Goldman Sachs, Morgan Stanley, JP Morgan Chase, and Bank of America.

Full post as published by Representing Investors on January 13, 2010 (boomark / email).