• Lisa Simpson
• Aug 12,2010
• In: Foreclosure

CDO, Hedge Funds and Goldman

The CDO (collateralized debt obligation), hedge fund Paulson and Wall Street Goldman together made up a nice of cocktail of complex woes. Where did Goldman trip causing a civil suit to be filed against it – something that will cost its shareholders dear?

A hedge fund manager, John Paulson knew from the onset that the sub-prime mortgage backed bonds would default. But he bundled them together making a synthetic CDO. Then he could bet against it. He took part in the selecting and sieving of the securities that made it up, although the final decision was taken by a third party.

Goldman did not mention to the investors (various banks foreclosure in Europe) the involvement of Paulson. Basically Paulson wanted to bet and paid Goldman handsomely to find buyers willing to take up the bet. The bonds quickly collapsed and the banks paid huge sums to Paulson.

In this game someone has to be short and the other side long. The investors were not ignorant of this and it is thus questionable whether it is legally binding to disclose the identity of the short party to the future buyers.

This poses the question about the sensibility of doing such a thing and if it is to pubic interest.

The answer in both instances is positively negative. It just increases the risk and puts at stake the stability of the entire financial system. The basic point is why should banks be allowed to indulge in betting in the first place?

It is not a matter of being wise after being bitten. The whole game involving CDOs were ridiculous from the very beginning. It indicated the mental mindset of the financial warlords at the time of triggering off the bubble.

What can be done to avoid a repeat? Financial products in general allow the investor to manage the risk while someone provides the capital.

None got any capital out of these deals. Risk could have been managed by opting for more traditional contracts with the backing of yardstick or index that could be traded openly on public exchanges. It is not ethical for bankers to make use of the funds of depositors to bet on deals that are secretive and not open. Nothing can be said in their defense.

Dealing in stocks makes the market more fluid, prevents formation of bubbles and allows for investors to have an incentive in doing their homework so that fraud can be immediately identified.

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• foreclosures and hedgefunds
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