My last post linked to an article that detailed how a hedge fund helped create CDOs and then bet against those CDOs. Today, the SEC charged Goldman Sachs with doing nearly the same thing. Goldman, according to the civil suit filed today, allowed hedge fund manager Paulson & Co to select mortgages for inclusion into CDOs. Paulson selected the mortgages it felt had the most default risk. Goldman then sold the CDO to institutional investors while Paulson bought a credit default swap (insurance) that paid off when the CDO defaulted. Here is an explanation from the New York Times:
According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.I like this paragraph near the end of the article. Our old friends at AIG, of course, provided the insurance through the credit default swaps that made Paulson so much money:
Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.
But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.
In seven of Goldman’s Abacus deals, the bank went to the American International Group for insurance on the bonds. Those deals have led to billions of dollars in losses at A.I.G., which was the subject of an $180 billion taxpayer rescue. The Abacus deal in the S.E.C. complaint was not one of them.