Wednesday, April 21, 2010

Waldman on Abacus

I'm a great admirer of Steve Waldman and I'm still trying to make up my own mind about Abacus so I pricked up my ears this morning when I'd heard he had weighed in to savage Goldman. What set him off is this line from the Goldman "defense:" "These [CDO buyers] also understood that a synthetic CDO transaction necessarily included both a long and short side." Steve pops a cork:

The line I’ve italicized is the sole inspiration for this rambling jeremiad. That line is so absurd, brazen, and misleading that I snorted when I encountered it. Of course it is true, in a formal sense. Every financial contract — every security or derivative or insurance policy — includes both long and short positions. Financial contracts are promises to pay. There is always a payer and a payee, and the payee is “long” certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. Old stakeholders commit to pay dividends to new shareholders because managers believe the cash they receive up front will enable business activity worth more than the extra cost. New shareholders buy the shares because they agree with old stakeholders’ optimism. The existence of a long side and a short side need imply no disagreement whatsoever.
There's more, but even on this, Steve seems to think he has made hash out of Goldman's position. And he has his defenders: James Kwak says it is "The best thing I've read on SEC--Goldman (So Far)" (link) (cf, also the long comment threads following Waldman and Kwak.

But the more I read in around the topic, the less sure I am that Steve is right. Or, maybe he is somewhat right, a little bit right, partly right--but I don't see Goldman's statement as "absurd." At least in this context, I suspect that the statement "for every long there's a short" is, if not exactly true, still close enough.

Start with the world of deals. Clearly there are deals that are win-win--in the jargon of the trade, "Pareto maximizing." If I have a brand new pair of roller skates and you have a brand new key, why then we can make beautiful music together. If you have a skillet and I have a fish--well, you get the idea.

But in a thousand years of teaching, I have never quite convinced students that Wall Street is really like that. As far as they can see, it's all a series of guesses--some right, some wrong. But insofar as it is just guessing, it's zero sum. For every long there's a short.

DeLong sees the problem and makes a heroic effort to talk his way out of it, but he doesn't sound quite convinced himself--indeed he scrutinizes one of his own examples and then kicks a hole in it. Yes, there may be "insurance" or "time preference" or "risk aversion." But a lot of Wall Street is long-short.

But I don't mean to let Goldman off the hook. The trouble with Goldman's argument is not that it is "absurd;" the trouble lies elsewhere. The trouble is that all this long/short stuff is quite beside the point. The question is still what the buyer knew or should have known, what the seller said or should have said. So maybe Steve is right to say that the GS position is "misleading;" maybe even "brazen." But not "absurd."

Afterthought: there is still, of course, the question of why on God's green earth anybody should be permitted to engage in a transaction potentially so destabilizing and with so little apparent social utility. But that is for another day.

1 comment:

elrojo said...

those of us who knows next to nothing of the intricacies of investment shenanigans can still discern that there needs to be some hangings of goldman execs on the light poles outside its wall street building. i mean after trials, west of the pecos style trials.