Why aren’t synthetic CDOs considered illegal “wagering contracts”?

I’m not a Wall Street lawyer, so I’m asking a novice question here, but I would like to know why the synthetic CDOs created by Goldman Sachs aren’t considered “wagering contracts” void under New York state law?  Before I read Michael Lewis’s fantastic book “The Big Short” I had never heard of synthetic CDOs.  Lewis explained how Goldman Sachs and other Wall Street firms created synthetic CDOs to allow investors to place a bet on the probability that subprime mortgages would pay off.  The synthetic CDOs allowed investors to bet on the mortgages without having any ownership interests in the mortgages themselves.  It was purely and simply a gamble.  Investors who believed the mortgages were healthy could go “long” on a synthetic CDO, while investors who thought the mortgages would default could go “short.”  If the mortgages defaulted (as they did), the shorts made fortunes, while the institutional longs lost fortunes.

In almost every state, a gambling contract (also called a “wagering contract”) is considered null and void because it is deemed to violate public policy. Two Wall Street Banks can’t legally bet $500 million on the outcome of the Boston Red Sox vs. New York Yankees baseball game.  In fact, all fifty states have laws prohibiting the sale of insurance to someone who doesn’t have an “insurable interest” in the subject of the insurance policy, because a policy sold to someone without an insurable interest would be considered a wagering contract and, therefore, void.  Life insurance policies are null and void if the beneficiary doesn’t have an “insurable interest” in the life of the insured person, and property insurance policies are void if the beneficiary doesn’t have an “insurable interest” in the property that is insured. Thus I can only buy a policy of life insurance on my spouse, children, parents, business partners or someone else in a close relationship to me.  If I try to buy a life insurance policy on Hardball’s Chris Matthews, or my elderly next-door-neighbor, I can’t do it.  It would just be a gambling contract, and void.  Similarly, I can buy fire insurance on my house, but I can’t buy a policy of fire insurance on the local Olive Garden restaurant.

When I read Michael Lewis’s explanation of synthetic CDOs, I immediately asked myself why these contracts weren’t void. The people buying and selling the CDOs didn’t have any interest in the subprime mortgages that were the subject of the CDOs.  Both buyers and sellers were simply betting whether the mortgages would pay off.  Simply put, the synthetic CDOs were wagering contracts.

Many of the news articles covering the SEC’s lawsuit against Goldman Sachs fail to adequately explain what synthetic CDOs are. The Financial Times explains it as well as anybody. FT writes:

First, mortgage lenders make loans (in this case, to “subprime” borrowers with poor credit histories). Second, those loans are packaged up in mortgage-backed bonds. Buyers of the bonds receive the interest payments and bear the risk of default. Third, those bonds, with others, are used to back a collateralised debt obligation, a bundle of bonds. These CDOs are then sold to investors, who buy them because they behave like normal bonds, but pay out more interest.

To make a synthetic CDO, we need a credit default swap. This is like a two-way insurance contract. In essence, the first “short” investor agrees to pay the CDO’s interest payments to the second “long” investor. In return, the “long” investor must make the “short” investor whole if the underlying CDO defaults. There is no need for either investor actually to hold the CDO. For the long investor, it is as though they have “synthetically” bought a CDO – the payments if it survives, and the costs if it defaults, are the same as if they actually owned it. (emphasis added)

There are sure to be Wall Street and SEC lawyers who looked at this issue long ago, but I haven’t seen the issue addressed. Just to satisfy my curiosity, would somebody please tell me why the synthetic CDOs aren’t void wagering contracts?

Tagged as: derivatives, gambling contracts, Goldman Sachs, Michael Lewis, subprime mortgages, synthetic CDOs, The Big Short, wagering contracts