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Mar 06

Synthetic CDOs, Conflicts of Interest, and Securities Fraud

Jennifer O’Hare

Following the financial crisis, the synthetic collateralized debt obligation (“CDO”)—a complex derivative that received little mainstream attention prior to the housing meltdown—became big news. Journalists wrote numerous articles explaining how synthetic CDOs spread the contagion of toxic assets throughout the financial system, nearly bringing down the global economy. Government hearings exposed the ugly conflicts of interest inherent in the structuring of synthetic CDOs, as big investment banks created, sold, and invested in synthetic CDOs and often bet against their clients. Some of the world’s largest financial institutions, who faced bankruptcy when their investments lost value, bitterly complained that these synthetic CDOs had been “designed to fail” so that the investment banks could profit at their expense. Greedy investment banks were seen as the problem, not the synthetic CDOs themselves.

As a result, the Securities and Exchange Commission (“SEC”) sued several of the highest profile investment banks for fraud, and some investors in synthetic CDOs brought their own private actions for fraud against the investment banks. Calls for increased regulation of synthetic CDOs resulted in legislation prohibiting investment banks from engaging in certain conflicts of interest in the sale of synthetic CDOs.

This article shows that focusing primarily on the misconduct by investment banks or on the corresponding harm suffered by investors has caused regulators to miss the real issue: the sale of the synthetic CDO. Outrage over the extraordinary greed and sometimes outrageous misconduct by investment banks in the sale of synthetic CDOs is understandable. However, it was not the bad behavior of the investment banks that furthered the financial crisis; it was the use of the synthetic CDO itself. Because the regulators focused on the wrong problem, the dangers caused by synthetic CDOs still exist and must be addressed through additional regulation.

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