Monday, April 19, 2010

If you want to understand the Goldman Sachs case

You should go read this concise and insightful post by economist Brad DeLong. Here's my short version:

Goldman got a request to create a security made up of specific mortgages, just so the requester could bet against those mortgages. He thought they would be worth a lot less in the future.

Goldman made such a security and then sold it to other investors. By buying this security, these investors were betting that the mortgages would not fail and they were on the other side of the bet from the original requester. It appears these investors did not understand this was the case.

The potential problem for Goldman is in how they sold this security they made to the investors.

The investors appear to have believed that they were writing insurance on a general pool of mortgages. They weren't. In fact, they were betting on a pool of mortgages that were hand-picked by that original requester for their failure potential.

It remains to be seen if the investors got the idea that they were writing insurance just because they wanted to believe that and didn't do a good job of understanding what they were buying (probably not a problem for Goldman), or did Goldman give them the impression that they were writing insurance on a general pool of mortgages when they weren't (most likely a problem for Goldman).

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