Randomly Noted

The abacus, like the one pictured above, was a simple tool devised centuries ago to help people count and add.

The ABACUS 2007-AC1, a synthetic collateralized debt obligation at the center of Wall Street’s latest scandal, was created not that long ago and is anything but simple. Earlier today, the Securities and Exchange Commission charged Goldman Sachs and one of its executives with fraud surrounding the sale of ABACUS. Investors lost at least $1 billion and hedge fund operator Paulson & Co. picked up that amount. The charges and scandal will lead to renewed calls for tough regulation on Wall Street. And may lead to more debate about whether structured products are good or bad for financial markets.

Structured financial products like plain vanilla asset-backed securities are a good thing. A bank writes a mortgage or car-loan and sells it to an asset backed security. The asset-backed security is then bought by a wide pool of investors. The bank has freed up money to lend again. And the asset-backed security allows for a diverse pool of investors.

What got a little crazy was the creation of a new asset-backed security – the collateralized debt obligation, which basically just invested in other  asset-backed securities and bonds on a very leveraged basis.

And what was downright nuts was the creation of something like ABACUS. This synthetic CDO didn’t invest in anything real – just insurance contracts (credit default swaps) that were to mimic crappy subprime mortgage securities owned by someone else. And then on top of that, there were firms that offered insurance on the not-real bonds. And then in this case, there was a bank that offered reinsurance on top of that insurance.

This was all about creating a highly leveraged vehicle that was nothing more than a high-stakes gambling game. The credit markets are suposed to be a place where money is raised by companies and individuals (in the case of asset-backed securities) and put to good use toward future growth. The credit markets are not a place where make believe securities should be sold for the benefit of a couple of sharpies (in this case, Goldman Sachs and Paulson & Co.)

We will likely hear that all structured financial tools should be eliminated because of the damage they caused. Good structures, like asset-backed securities that hold good assets, should be allowed to continue to thrive. But structures like the ABACUS garbage should be permanently tossed to the trash heap.