George Soros on derivatives:

[kentuck]

received in an email:

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

[The Magistrate]

1. Spot-On, Sir....

[kentuck]

2. How are you feeling nowadays, Magistrate?

I don't see you around as much. Hope you are doing well?

[The Magistrate]

3. Well Enough, My Friend

Things are healing slowly.

Thank you for your concern.

[kentuck]

4. Take care.

We are thinking of you.

[Hubert Flottz]

5. derivatives = stealing.

Bank Robbers beloing in jail.

[Phoebe Loosinhouse]

6. Leverage is a major problem

Should the casino be allowed to lend a large multiple of all the existing monies in the world? Even at 2:1 you still make a hundred percent on your bet. I think it's great that it is becoming common knowledge that the markets are gambling casinos with loaded dice in favor of the big players. Why give them your money to buy the clubs to beat you with?

I absolutely advocate putting your money in CDs, money markets, Tbills or whatever even though they are paying zilch right now, simply to show that you are tired of being the shill in the 3 card monte game. That is the sum total of your power to protest in any meaningful fashion.

[The Magistrate]

7. Indeed, Ma'am: Betting Money You Do Not Have Cannot End Well