Posted by Karl Denninger
Goldman is now being formally investigated by the FSA, the UK’s equivalent to the SEC:
“Following preliminary investigations, the Financial Services Authority has decided to commence a formal enforcement investigation into Goldman Sachs International in relation to recent SEC allegations,” the FSA said in an e-mailed statement. “The FSA will be liaising closely with the SEC.”
Notice what Alistair Darling said yesterday:
Chancellor of the Exchequer Alistair Darling said today that regulators need to take urgent steps and that the charges against Goldman Sachs had “huge ramifications.” Darling, who described the securities Goldman sold as “a bag of pus,” said the government would look at changing the law if necessary.
The squid appears to have fewer tentacles into the UK’s government than it does into ours. Note carefully that our President, and both of OUR political parties, have not come clean on what was being sold – and exactly what practices were involved here.
But Bloomberg gets this part of the story wrong:
Banks create CDOs by bundling bonds or loans, or both, from numerous issuers such as companies or countries. Interest payments on the underlying debt is then used to pay investors.
The CDOs in question were synthetics – that is, they were not bundled up bonds, but rather they came into creation as a consequence of a credit-default swap being purchased by someone who wanted to short the reference, in this case Paulson’s hedge fund.
A CDO can be comprised of any instrument (or set of instruments) that throws off a cash flow. In this case there were no physical bonds involved in the transaction; it was entirely comprised of credit-default swaps, which create an obligation to pay a coupon flow (from the buyer of the CDS) to the CDO which then distributes that cash flow to the buyers of the tranches of the CDO.
Here’s the problem with these things: There is no economic benefit and real party at interest underlying these structures!
So why do we allow this sort of thing to take place at all? The banks love these “structured products” because they get to skim off a fee. But unlike a public sale of stock or bonds, these are nothing more or less than raw gambling contracts for which the banks collected a fee.
That is, they are inherently negative-sum games that are being played!
The only reason to set up these structures in the first place is to keep them off an exchange, where we have price, open interest and execution transparency. That is, if I want to short something I can do so on a public exchange but in doing so the terms are standardized and I cannot take advantage of anyone by hiding information.
There is no reason for regulators to permit this sort of complicated scheme that amounts to the bundling of naked credit-default swaps, as such structures are always, in one form or another destructive of capital on balance.