CDO

During the run up of the mortgage crisis large investment banks took groups of individual home mortgages and bundled them into a type of bond called a collateralized debt obligation (CDO’s) and sold these on the bond market. They were able to pay a higher interest rate than other bonds at the time since typical home loans were sold at 6 to 8 percent and most bonds at that time were paying half of that. As long as new mortgages kept coming in they had a supply of these bonds to sell so lenders were encouraged to offer a mortgage to any warm body. If it had been limited to that the damage may have been held to a couple of trillion but a new product emerged that exacerbated the problem. The new product was called a synthetic CDO and while CDO’s were backed by actual mortgages these new products were derivatives and were backed by credit default swaps. This means that they were just paper based on bonds and they were insured in case they went bad. The problem is now greatly enlarged because with regular CDO’s you were limited by how many mortgages you could find but the synthetic CDO’s had no limit since they were not based on any real product and the potential risk now went from a couple of trillion to many trillions.

Next enters a hedge fund. A hedge fund is a group of wealthy individuals who combine their funds to purchase various investments. In this case the hedge fund was operated by John Paulson and one of its more well known investors is George Soros a man whose money was instrumental in the Obama campaign. Paulson had worked closely with Goldman Sachs over the years and convinced one of their bond experts to allow him to select a group of CDO’s that he knew were of very poor quality and to sell them to other investors like the Royal Bank of Scotland. These instruments were doomed to fail but those who bought them were unaware. Next Paulson sold these funds short. That means that if they go down in value then he profits and in this one fund called Abacus he made over one billion as the fund collapsed. Now the SEC is suing Goldman Sachs for knowingly selling these products without telling the buyers who selected the bonds, in this case the aforementioned Paulson. Had they known that they would have been more diligent since Paulson was well known for selling short. Paulson’s defense is sound in that he did not sell these instruments but they were sold by Goldman Sachs. Goldman’s defense is that the buyers should have exercised due diligence and investigated the make up of these bonds before they purchased.

The case will now be decided by the courts but my guess is that neither Goldman nor Paulson will be found guilty. We will see over the coming months how this plays out.


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Jack/John