What is the social value of a synthetic CDO?

The SEC charges that Goldman Sachs defrauded customers when it sold them synthetic CDOs without telling them that the securities that comprised them had been selected by a hedge fund precisely on the basis of their having a high probability of default. What, I hear you asking, is a synthetic CDO? Well, see if you can follow the bouncing ball:

- A mortgage, from the perspective of the lender, is a security that pays a fixed amount each month for 15, 20, or 30 years (I'm referring to conventional mortgages here).

- A mortgage-backed security (MBS) is a pool of mortgages. Like a mutual fund, it is a security whose payments are generated by the mortgages it contains.

- A collateralized debt obligation (CDO) is a pool of MBS. Its payments are generated by the payments on the MBS it contains, with the complication that the CDO divides payments into risk classes or "tranches." Any defaults on the underlying MBS are assigned to the lowest rated tranche first, then to higher level tranches as needed, so that if you buy the highest tranche you are insulated from most of the defaults on the underlying MBS.

- A credit default swap is a transaction in which one party makes small periodic payments to another party as long as an underlying asset such as a CDO continues to generate payments, and makes a large payment in the reverse direction if the underlying asset defaults. It is essentially an insurance policy on the underlying asset.

- A synthetic CDO is a collection of credit default swaps whose payment structure is designed to mimic the payment stream that would be generated from a CDO.

That's simple enough. But the question that naturally arises is the one posed by Andrew Ross Sorkin: "What purpose does a synthetic C.D.O., which contains no actual mortgage bonds, serve for capital markets, and for society? To answer this question, we turn to the Book of Keynes, Chapter 12. Read the whole chapter, it is chock full of insights. But the relevant passage for the present question is this:

In former times, when enterprises were mainly owned by those who undertook them or by their friends and associates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, not really relying on a precise calculation of prospective profit... Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (though not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and II in the morning and reconsider whether he should return to it later in the week...

Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. This is the inevitable result of investment markets organised with a view to so-called 'liquidity'. Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of 'liquid' securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is 'to beat the gun', as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow...

The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only. But a little consideration of this expedient brings us up against a dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is 'liquid' (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.

The answer is liquidity. Mortgage-backed securities make mortgages more liquid, hence more valuable to the lender, hence available at a lower price (interest rate) to the borrower. CDOs make MBS more liquid, hence more valuable, which further lowers the rate at which lenders are willing to extend mortgages. Credit default swaps make CDOs more liquid, and synthetic CDOs do the same. The social benefit from all these derivatives is greater liquidity for assets that by their nature are illiquid, hence lower mortgage rates for prospective homebuyers. The tradeoff is, in a financial panic investors try to exercise the liquidity value of these investments. But the house itself that is the asset underlying the pyramid of finance is not liquid, and therefore the rush for liquidity creates a collapse in the real economy.

But the argument for MBS, CDO, CDS, synthetic CDO and the like presumes that the liquidity value priced into these instruments reflects the true risks associated with each of these assets. The current situation has arisen in part because these assets were mispriced, which resulted in overinvestment in the underlying asset (housing). They were mispriced for a number of reasons, including stupidity on the part of market participants, corruption of the rating agencies, and (alleged) fraud on the part of institutions like Goldman Sachs. One way to increase the probability that these types of securities are correctly priced is to force them to be traded over organized exchanges rather than "over-the-counter" as in the Goldman Sachs deals. This is one of the most important elements of the financial reform bill that the Democrats are trying to pass. But Keynes tells us that even if assets are correctly priced in ordinary times, the function of financial markets of making fundamentally illiquid assets like houses appear to investors as liquid assets presents a dilemma: though it fosters investment, it also makes the economy susceptible to periodic panics that result in economic crisis.