Last spring, in another forum, I blogged extensively about the SEC v. Goldman Sachs kerfluffle, having come to the conclusion that it was all a battle of competing metaphors, one employed by the finance people who actually knew what they were doing, and one employed by the SEC and others who wanted to do, well, something to to Goldman Sachs. The gist of my position was pretty simple: what Goldman Sachs constructed for very sophisticated investor/speculators was an instrument that paid a return based on index measured by the performance of a hypothetical portfolio of mortgage-backed securities. You invested in this package if you believed the value of the portfolio was going to go up. What the SEC alleged is that Goldman didn't disclose that, although there was an independent party assessing the portfolio that created the index, it had been originally selected by another investor/speculator who wanted to bet against its performance. The SEC-Carl Levin metaphor was that GS's relationship with its clients on this deal was as trusted advisor-fiduciary, and the failure to disclose was material because there was a fiduciary obligation to disclose that kind of information with full candor. The more appropriate metaphor (in my view) was that of bookie: anybody investing in this instrument would have to know that GS would not speculate, but would only facilitate the speculation of others, and hence would necessarily have to be taking opposing bets. (The idea is that when any betting facilitator, whether a bookie, a racetrack, or a casino, pays off the winners, it does so with the losing bets of the losers, and it sets the odds or payoffs so that it makes a skim or "vig" as the bookies call it.)
I was always skeptical, nay, cynical, about the SEC's motivation for the lawsuit, and am even more cynical now, as I realize that the financial markets continue to be replete with precisely the same kinds of transactions, having been offered to invest in one myself in the last few days. This is not a criticism of the banks that construct the instruments; to the contrary, there's a place for this kind of instrument in the assembly of a hedged and balanced portfolio. But there's no substitute for due diligence and realistic thinking. Indeed, if you don't understand what follows, be careful about making a normative judgment!
Here's how it works. Suppose there a large and well-respected financial institution, call it Bank of Antarctica (BoA) that wants to raise some capital. It could issue equity, but that's expensive, or it could issue debt, but that may not pay enough interest to be attractive. So it says, let's issue our notes, but not pay interest on them. What it will do is set up different indexes, the Russell 2000, the Singapore 50, the S&P 500, whatever, and pay the noteholders back on maturity depending on how those indexes perform relative to a benchmark set on the date of issuance of the notes. The kicker is that we'll add some juice to the payback, so that the noteholder gets a "leveraged" or amped-up return on the performance of the index. BoA can even afford to give some "downside protection": if the market goes against your bet, you don't suffer until it is at least a 10% loss. That way if the potential noteholder really likes the short-term prospects of some area of the market, she can double down, put his money where his mouth is, go all in, you pick the cliche. The brilliant thing is that there will always be people who are inclined to bet against those same indexes (that's what makes horse racing and stock picking!), so BoA can act as the house by offering Bull notes, where the payoff is for positive performance in the index, or Bear notes, which are exactly reversed. And if the Bulls and Bears don't balance, BoA can always go out and purchase or sell derivative contracts that have the same hedging effect.
This is a win-win-win. BoA gets a capital infusion in the form of debt, but hedges its exposure, knowing that it will have the funds to pay the winners their leveraged returns from what it doesn't have to pay the losers, the result being that it will have gotten debt financing not only cheaper than equity, but even perhaps cheaper the going rate for debt, even for great credits like BoA. Investor-speculators, whether Bull or Bear, who want to make bets on the direction of the market over the term of the notes have an opportunity to do so.
As I said, an account executive at a major investment bank offered me the opportunity to invest some of my IRA in Bull notes (I am an "accredited investor" but that's not saying much). Here's the lesson in finance for grownups. I said, "I am not smart enough to understand and make a decision about this over the phone. Nobody gives away something for nothing. If the issuer of the note is promising to pay a premium over market performance of an index, there has to be some corresponding setoff somewhere. Send me materials so I can read them and figure out where." What I figured out - it's all there, just as it was in the Goldman kerfluffle - is what I've written above.
I did, however, decline to invest in the notes. Why? Because the price of the premium is that I would be making a bet on the performance of the market, not over the ten to twenty year timespan that is relevant to my financial planning, but over the three-year term of the notes. I'm willing to believe that the markets will go up over the long-term, but I have no clue what any of these indexes are going to do in three years. It's possible that someone has a need to hedge other market exposures, whether long or short, over the next three years, but that ain't me.
UPDATE: My broker tells me my analysis in the last paragraph is wrong. If one buys the three-year note and the market is down on the redemption date, the buyer is no worse off than she would have been had she been long in the same stocks on that date. Yeah, that's true - and she could reinvest (particular as in the IRA there's no tax consequence). Then the question is whether a market develops in the notes so that if you want to rebalance midway through you have a way to sell the notes. Broker says markets do develop. So the "grownup" issue isn't whether this is a speculative derivative; it's probably not. The grownup issue is nevertheless that Bank of Antarctica, no more than Goldman Sachs, cares whether the market goes up or down as long as it, the issuer of the instrument, is fully hedge.