The US Security and Exchange Commission’s civil suit against Goldman Sachs will be vigorously contested by the defendant. It is interesting to speculate which side will win; but we will not know the result for months. Irrespective of the eventual outcome, however, the case has far-reaching implications for the financial reform legislation Congress is considering.

Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralised 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. The primary purpose of the transaction was to generate fees and commissions.

This is a clear demonstration of how derivatives and synthetic securities have been used to create imaginary value out of thin air. More triple A CDOs were created than there were underlying triple A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors. The process went on for years and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It cannot be allowed to continue. The use of derivatives and other synthetic instruments must be regulated even if all the parties are sophisticated investors. Ordinary securities must be registered with the Securities and Exchange Commission before they can be traded. Synthetic securities ought to be similarly registered, although the task could be assigned to a different authority, such as the Commodity Futures Trading Commission.

Derivatives can serve many useful purposes, but they also contain hidden dangers. For instance, they can pile up hidden imbalances in supply or demand which may suddenly be revealed when a threshold is breached. This is true of so-called knockout options, used in currency hedging. It was also true of the portfolio insurance programs that caused the New York Stock Exchange’s Black Monday in October 1987. The subsequent introduction of circuit breakers tacitly acknowledged that derivatives can cause discontinuities, but the proper conclusions were not drawn.

Credit default swaps are particularly suspect. They are supposed to provide insurance against default to bondholders. But because they are freely tradable, they can be used to mount bear raids; in addition to insurance they also provide a license to kill. Their use ought to be confined to those who have a insurable interest in the bonds of a country or company.

It will be the task of regulators to understand derivatives and synthetic securities and refuse to allow their creation if they cannot fully evaluate their systemic risks. That task cannot be left to investors, contrary to the diktats of the market fundamentalist dogma that prevailed until recently.

Derivatives traded on exchanges should be registered as a class. Tailor-made derivatives would have to be registered individually, with regulators obliged to understand the risks involved. Registration is laborious and time-consuming, and would discourage the use of over-the-counter derivatives. Tailor-made products could be put together from exchange-traded instruments. This would prevent a recurrence of the abuses which contributed to the 2008 crash.

Requiring derivatives and synthetic securities to be registered would be simple and effective; yet the legislation currently under consideration contains no such requirement. The Senate Agriculture Committee proposes blocking deposit-taking banks from making markets in swaps. This is an excellent proposal which would go a long way in reducing the interconnectedness of markets and preventing contagion, but it would not regulate derivatives.

The five big banks which serve as marketmakers and account for over 95 per cent of the US’s outstanding over-the-counter transactions are likely to oppose it because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. These considerations ought not to influence the legislation.

The writer is chairman of Soros Fund Management

The biggest winners are the military contractors. Here they are in order.
Lockhead Martin $31.3bn
Boeing $20.9bn
Northrop Grumman $16.1bn
General Dynamics $15.9bn
Raytheon $15bn
United Technologies $7.1bn
L3 communications $7.1bn
Bae Systems $6.8bn
Oshkosh $6.4bn
KBR $4.7bn

Greece: 124.9
Italy: 116.7
Begium: 101.2
Portugal: 84.6
Eurozone Average: 84
Ireland: 82.9
France: 82.5
UK: 80.3
Hungary: 79.8

People have lost faith that the PIIGS countries can pull themselves out of their huge budget problems.  So to avert risk investors are flocking to US treasuries.  All of this has created huge one day drops in markets around the world.  Gold was down 4.3 percent closing at $1,062.  Greek equities felll 3.89%, Portugal’s stock market lost 4.98%, Spain 5.94%, S&P500 3.11 percent, FTSE 100 2.2% and the price of oil down 5%.  As another sign of problems for the EURO credit default swaps or the cost of insuring debt of soveriegn nations has skyrocketed in the PIIGS countries.  With no sign of stopping any time soon.

With all the outrage over banks lately I decided to write a quick summary of the largest banks in the world.  This is to help people put in perspective how large certains banks actually are.  All of these figures are based on the revenue of the bank. 

I cannot agree more. People flock to gold during times of economic crisis. I wrote a previous blog entry on this that goes more into detail. But gold is due for a major downswing.

The first thing to consider is the law of supply and demand, basic economics here.  If the supply of houses increase the price should go down and if the supply decreases the price should go up.  So naturally let us first begin by using Trulia to determine the supply.  I realize this is a crude way of determining the supply but I’m looking for something simple.  I don’t feel like logging into ARMLS to pull these numbers.  In the box below if you click on the “Inventory” tab towards to bottom right you can see the trend is going upwards(1/26/2010). 

Tempe Real Estate – Trulia.

If you mouse over the end you’ll see it’s at 689 compared to a year ago at 516.  This tells us that there are more houses on the market now than a year ago.  According to this trulia graph almost 25% more.  Therefore we should conclude that until this supply starts to come down you should not consider buying a house.

Here is a shorter term example.

Next let’s take a look at raw prices of houses over the last year in this area.  This is the same graph as the one before except we’re not going to click on the “Inventory” tab.  Instead we’re going to leave it on the default of “Price”.

Tempe Real Estate – Trulia

You can see from this graph that prices are on a downslide.  Until this graph starts to turn upwards I would not considering buying a house.  Some people argue that if you wait until it starts to turn around then you’ll be too late and have to pay more.  This mentality will do nothing except get you in trouble.  Sure you may be right and call the bottom of the market.  But look at the downside if you’re wrong.  What if the property drops another 25%?  Some “experts” said the market would not move lower when it was still close to its highs in 2007.  Where would you be today if you bought a house then?  Do the right thing and wait for this graph to start an upward turn.

On a brighter note the median house price was up 1.5% in December at $178,300. It appears our lesson of the crash is yet to be learned. 1.5% annualized is 18%. A number that is unsustainable. Albeit this could just be the markets pulling towards their equilibrium. So in November home sales had peaked for the year and prices rose in December. There are two ways to solve this problem, government regulation or raising interest rates. Should the government intervene with the markets? Or let them run their course?

In March the governments program of buying mortgage backed securities is set to expire. This will be an interesting time to watch what happens.  In December we witness the largest slow down of housing sales since 1968.  One thing we know for sure is that our economy rests on government injection of capital.  The question is how long is this sustainable…