CDS And CDO : Why Financing And Gambling Needs Divorce

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In the year 20002 , legendary investor Warren Buffet famously said “ Derivatives are the weapons of financial mass destruction “ . Few understood its implication then, and even now two years after the global meltdown, largely caused due to the CDS meltdown. The twin reasons of the success of CDS is that it is complex, and that it is beyond the domains of statutory approvals , as per the financial laws of today. In short it is a quick, scalable and deregulated instrument, that sets a negative bet on a business or a city or a country , that has a publicly listed issue at a stock exchange.

The ICE Exchange at London or the official Mecca of the hedge funds transacted CDS worth $ 7 trillion in the last quarter, which is slightly above Americas GDP, twice more than China’s and about 5 times of most other G 20 nations. Importantly, it created the huge profits that the big Wall Street banks flaunt today , even as rest of America struggles with recession and recovery . What is this CDS or the credit derivative swap at the futures market and how do hedge funds drive the global economy today .

Short selling of stocks has long been a legitimate method to keep them realistically priced and avoid needless asset bubbles from forming. It helps investors to understand the importance of calculating the true value of a stock, so that promoters do not defraud them with rosy unrealistic promises. Contrary to popular notion, short-sellers are not market breakers, but market makers and help to keep the market liquid with investor funds flowing in both ways.


In a way Paulson in the Goldman case was a legitimate short-seller. He felt that the housing mortgages market was overheated, and wanted to short sell a bundle of BBB mortgages that he felt were overpriced, and approached Goldman for the same. The reason why SEC did not charge Paulson was because he did nothing wrong.

Goldman's theory of managing conflicting interests made them agree to Paulson request and help find suckers for the short selling game. The think tank did some cool calculation, that helped them both earn commissions as well as set up the ABACUS fund through the sucker company ACA management. Goldman advisors ensured that Paulson's list was represented in the ABACUS fund without the ACA getting a wiff of it. Thereafter it brought in sucker clients like IKB and ABN Amro for investment without them knowing about Paulsons intention. Whereas we are not discussing the merits of the SEC case here, we are simply explaining that why CDS and CDO's are weapons of mass destruction as Buffet famously said.

This disclosure and stauatory approval of all CDS and CDO's is a must to avoid such financial gambling. Backroom boys at Goldman Sachs must not be permitted to write any decree to short a stock or a bond, in the form of an exotic CDS or synthetic CDO or any other financial derivative, to destroy a public issue that has gone through statuatory approvals.

Transparency and fairplay demands that a derivative or a CDS must go through the same sort of approvals, as a public issue does, if it has to be a tradable commodity. The problem today it is not so, so Dollar 70 billion of public issues each quarter face Dollar 7 trillion of CDS or short selling, not to ensure market liquidity but to create market volatility.