George Orwell’s classic novel, Nineteen Eighty-Four, describes a political ceremony called the Two Minute Hate, featuring Public Enemy Number One, a reprobate named Goldstein. People attend official rituals to work up a frenzy of hatred against Goldstein and love for their protector, Big Brother, or B-B.
To quote Orwell, at the climax of the Two Minute Hate, “the entire group of people broke into a deep, slow, rhythmical chant of “B-B! … B-B! …B-B!” – over and over again…” This daily rite is supplemented with elaborately prepared Hate Weeks.
In the past week there has been a similar fury in the media against Goldman Sachs, with herds of pundits all expressing their horror of the derivatives deal that is at the center of the Securities and Exchange Commission’s fraud case against the investment bank. This campaign starts with chants of “Social Benefit! Social Benefit! Social Benefit!” and climaxes with “Regulation! Regulation! Regulation!” Thus a mythical regulator stands in for B-B.
To pick one example out of many, George Soros writes that “Whether or not Goldman is guilty, the transaction in question clearly had no social benefit.” Mr. Soros is wise to hedge his bet about Goldman’s guilt—the SEC complaint contains holes the size of the real estate bubble. But was the mortgage-based collateralized debt obligation really devoid of social value?
“This synthetic collateralized debt obligation did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst,” Mr. Soros charges.
As a synthetic debt obligation, the investment vehicle did not buy mortgages but rather a kind of insurance, credit default swaps, for a reference portfolio of mortgage-backed bonds. So the question really is about credit default swaps. Do these derivative instruments have social value? Once you look at it that way, it is obvious that they do. Like any financial instrument, they act as signals.
In this instance, CDS signaled that the property bubble was deflating. The hedge fund, Paulson & Co., whose role in the deal the SEC accuses Goldman of concealing, used CDS to bet against subprime mortgage-backed securities. So Paulson & Co. played the role that short sellers of over-priced shares played in the 1999 stock bubble.
Short selling is a market mechanism for limiting bubbles. To argue that the Goldman deal had no social use is in effect to argue that the bubble should have continued, become bigger and done more damage.
The real issue about CDS is not whether they are useful but how to make them more transparent and reduce the risk that writers of swaps might default. Because swaps are private contracts, information about them is hard to get, though CDS indexes developed in recent years act as indicators. Central clearinghouses are the solution to the problem.
Moving credit default swaps to centralized clearinghouses has already begun and exchanges have been working on it for some time. Regulatory bills now in Congress mandate this and the further step of exchange trading of CDS. To some extent it will happen regardless of regulation because the historic trend is to standardize financial instruments and trade them. In any event, none of these issues justify the virulent condemnations.
In the Orwellian dystopia, Goldstein was hated and despised by everybody yet remained a huge threat—according to official propaganda. He was essential as an easy target for channeling popular rage that otherwise might turn against the ghastly regime itself.
In our predicament, the coordinated attack on Goldman is used to push Republicans into a corner politically and get support for more aggressive financial regulation. But it may also have a broader aim—perhaps to take folks’ minds off matters like the role of public institutions such as Fannie Mae in creating the housing bubble and the current gigantic expansion of government in all directions.
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