Cognitive Dissonance in Structured Finance

The discussion emanating from the Goldman fraud allegation shines a light on the contradictory arguments that are used to defend the market in synthetic “assets”.

When one asks whether synthetic CDO tranches were a good idea, the standard response is:  Synthetic CDOs were necessary to meet the demands of investors:  The demand for AAA assets was “unlimited” and there’s no way the supply of cash assets could have filled that need, so synthetics were created to meet investors’ needs.

On the other hand when one observes that using a synthetic CDO to market a short vehicle as if it were appropriate for a long investor is dishonest, the response is:  But everybody knows that synthetic assets are backed by shorts, so it’s a case of buyer beware.

Clearly both stories of how synthetic CDOs work cannot be true at the same time.  Either synthetic CDOs are a benign development that allow financiers to better meet the needs of investors, or they are a particularly dangerous product where the investor always needs to be scrupulously second guessing the intentions of everyone else involved in the transaction.  It is precisely because outsiders are concerned about the latter — that is, how dangerous synthetic products can be for investors — that they question their right to exist and are told “Oh no, synthetics just meet a genuine investor need”.  Then when the SEC documents how noxious synthetics can be, we are told that the structurers of the product should be indemnified by the buyer’s duty to understand the product.  Well, if the latter is the case, then what possible justification is there for such natural vehicles for legalized fraud to exist?

The structured finance folk need to get their stories straight.

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