Synthetic CDOs, Conflicts of Interest, and Securities Fraud

Abstract

Synthetic collateralized debt obligations (synthetic CDOs) nearly brought down the global economy by spreading the contagion of toxic assets throughout the financial system. Following the crash, government hearings exposed the ugly conflicts of interest inherent in the structuring of synthetic CDOs, as investment banks such as Goldman Sachs created, sold, and invested in synthetic CDOs, often at the expense of their clients. Some of the world’s largest financial institutions bitterly complained that these synthetic CDOs had been “designed to fail” by the investment banks, so that the investment banks could profit at their expense. In this article, I argue that focusing primarily on the misconduct by investment banks, or on the harm suffered by investors, has caused regulators to miss the real issue: that the synthetic CDO is an incredibly dangerous derivative that needs to be strictly regulated and perhaps outright banned. I show that relying on the antifraud provisions of the federal securities laws to manage synthetic CDOs will not be sufficient to address the dangers. Similarly, I show that the proposed SEC rules prohibiting certain conflicts of interests in the sale of synthetic CDOS do not go far enough.

Keywords: Synthetic CDO, Financial Crisis, Securites Fraud, Reasonable Reliance, Goldman Sachs, "designed to fail"