Investments and bets

CDOs/speculation: Goldman Sachs may manage to ward off charges of fraud in the selling of its Abacus synthetic collateralised debt obligation. But the case raises a fundamental question about the relationship between finance and investment.

Housing finance certainly starts with virtuous investing: loans that put people in new and existing residences. But by early 2007, when Abacus was constructed, the U.S. mortgage market was primarily a playground for speculation - the polite word for gambling.

There were some players like German bank IKB betting that subprime mortgage valuations, which had come off their peaks, would stop falling and others, like the Paulson & Co hedge fund, which wanted to profit from further declines. The Abacus CDO allowed both sides to take a position.

No actual housing loans were made, or even repackaged. Rather, the Abacus CDO securities tracked the performance of mortgage bond derivatives - hence the “synthetic” epithet. Reality was several steps removed. The derivatives in turn tracked tranches of residential mortgage-backed securities, meaning the cash flows from the actual mortgages underlying those securities had already been sliced and diced.

The result of Abacus was a big loss for one party and a big gain for the other - Paulson, in this case. The courts will decide whether the odds were rigged, but regulators and lawmakers should consider if such wagers are appropriate in the first place.

For one thing, the lure of huge profits from speculative financial transactions probably encourages shady practices on both sides of the trade and in the middle. But the strongest argument against pure speculation is part economic and part moral. Investment in houses, roads and factories makes the world better and contributes to economic output. Speculation, by contrast, is a zero sum game, even before middlemen take their cut.

Speculators argue their activity can improve liquidity and price discovery. Also, apparently speculative holdings may actually have useful purposes. For example, a foreign company might be more likely to build a factory in Greece if it held credit default swap protection on Greek debt - a kind of hedge against political risk. But even if speculation does that much good, it probably does more harm. It’s time to make gambling in finance much harder to do.