06/18/2010 05:12 am ET | Updated May 25, 2011

The Goldman Sachs Scam Reveals the Rot in our Financial System

As the Goldman Sachs case unfolds, we will be tempted to focus exclusively on the fraud charges. After all, it sure looks as if Goldman Sachs failed to disclose that it was selling assets that were selected to fail by hedge fund honcho John Paulson, who then bet against the securities in order make a quick billion, while the investors lost an equal amount. The debate is likely to center on who should be charged with what.

But the real story goes far beyond this slimy, insider swindle. If we focus instead on the synthetic collateralized debt obligations sold by Goldman Sachs, we go to the heart of what crashed our economy. We need to look beyond our search for good guys and bad guys in this financial casino --all the big boys were, and still are culpable. That's because creating and selling synthetic CDOs was arguably the most profitable activity in the history of Wall Street. Unfortunately it also was the most dangerous for our economy. But unless we protest loudly, Congress will fail to regulate these "customized" derivatives

The first thing to note about the Goldman Sachs synthetic CDO scam is that the investments packaged and sold contained nothing real at all. There were no actual subprime mortgages bought and sold. There were no tangible assets involved in any part of the deal. Instead, Goldman Sachs sold a financial instrument that gained or lost value (and paid a rate of return) as if the synthetic product actually represented ownership in the tangible underlying assets.

For most of us this seems incomprehensible. How could a billion dollars change hands without involving a real asset (an actual mortgage with its claim to an actual home)?

For those of you who play fantasy sports this might make more sense. Right now about 10 million fantasy baseball aficionados (gamblers) "own" teams that reference real major league baseball players. But, of course, they don't "own" the actual 700 major league baseball players. Rather they just get to reference the statistics (home runs, stolen bases, etc) those players produce as if they owned them. Those fantasy baseball team "owners" bet against each other and real money changes hands. But nobody owns anything real at all.

Now just think for a moment what happens when fantasy finance replaces fantasy baseball in the real economy. It means that by creating and selling synthetic CDOs you can, in effect, sell the same asset again and again. This creates an upside-down pyramid of financial instruments which pirouettes precariously upon the underlying real assets.

In our economy we have about $300 billion dollars or so of imperiled or failed subprime mortgages. But through the miracle of modern financial engineering those pieces of junk were, in effect, sold several times over through synthetic CDOs. As a result, we ended up with several trillion dollars worth of toxic assets based on the limited number of underlying subprime mortgages and homes. When housing prices stopped their meteoric climb, the value of subprime assets crashed. When they did, the entire pyramid of fantasy finance instruments collapsed as well. The world now is littered with several trillion dollars of synthetic products. Their creation and destruction are a fundamental cause of the Great Recession. That's why Warrant Buffet called them "financial weapons of mass destruction."

Even the very "best" banks with squeaky clean reputations are accused of deceiving investors using synthetic CDOs. For example, the Royal Bank of Canada, which supposedly weathered the storm so well, is up against a very nasty law suit in Wisconsin involving the claim that the bank duped five school districts into buying $200 million worth of hot air. (See the first chapter of The Looting of America on

I had the opportunity to observe the Wisconsin scam up close. It was breathtaking. The local broker from the investment firm, Stifel Nicholaus, pitched the schools in behalf of the Royal Bank of Canada. It was all recorded on video. It seemed to me that he didn't know the difference between a synthetic CDO and a bratwurst. But he was a trusted salesman and advisor to the school boards, so the districts bought $200 million of synthetic CDOs, most of it with money borrowed from Depfa (an Irish bank that went under and now is owned by a German bank.) While the school districts thought they were buying a mutual fund of AA and AAA-rated corporate bonds to help fund educational liabilities, they ended up having their money used as a reserve fund to insure the junk debt held by the Royal Bank of Canada. And for the privilege of serving as an insurance company, the school districts, without knowing it, coughed up $11.5 million to the bank in up-front fees..

The $200 million was put in an offshore account and invested in short term AAA paper. The Royal Bank of Canada also put quarterly "insurance" payments into the fund. The school districts were supposed to get interest payments that would cover their loan and also provide a profit for the districts. In fact the school districts had purchased nothing real at all. They owned none of the underlying assets. They were the insurers..... just like AIG, and we all know how well that worked out.

When the financial crisis came, the bank's junk debt (that was insured by the schools' borrowed money) crashed in value, and the Royal Bank of Canada simply used the off-shore account as its piggy bank: it took the insurance money to make themselves whole. As a result, the school districts' $200 million is now worth about $600,000 and they still owe the $200 million on the money they had borrowed.

Here's the point: This crap was peddled by many banks and investment houses to pension funds, municipalities and investors all over the world. Each financial institution had its own version of the scam. The upfront fees were so juicy, none of them could resist playing the game. These are the "specialty derivatives" that Congress has exempted from regulation.

Here's the take-away: Synthetic CDOs must be banned. They are dangerous and have no redeeming value to our economy - none.

Now that the rock is overturned, we can watch the bank lobbyists scurry to defend "financial innovation" from the heavy hand of government regulation. Their case will be reinforced by hard cold cash tossed all over Congress - cash that has its origins in our financial bailout. It will be interesting to see if the Goldman Sachs uproar leads to a real crackdown on useless financial products, or whether it further diverts us from the core issues.

Les Leopold is the author of The Looting of America: How Wall Street's Game of Fantasy Finance destroyed our Jobs, Pensions and Prosperity, and What We Can Do About It Chelsea Green Publishing, June 2009.