Payback time

What goes around comes around! It was the investment bank Goldman Sachs who invented the credit default swaps. This bank has also directly been aware of the dangerous side of these mortgage insurance policies. Goldman came out as the winner of the credit crisis in 2008, the only bank that was still standing firm. But now it seems it’s her turn to be a target. Investors are furious and are claiming their losses back. It’s payback time!

What was it about this story and why was Goldman one of the biggest banks of Wall Street? This is the story: the provision of mortgages by banks is risky. Therefore, banks do everything to decrease their risks. People should have a fixed income and if possible some money in their account. Banks look at the income capacity of people who want a mortgage. It is important to estimate the benefits of the borrower’s risk management to get money back when it goes wrong. But suppose you can hedge that risk and sell it in an insurance to a third party. Suppose that the private mortgage cannot pay then the bank has insurance to cover the loss on appeal.

It was an excellent arrangement anyway. Risk diversification is usually the best way to cover shortfalls. And if the housing market moves in an ascending line, the coverage is ensured by increasing the value of the house. It leads to a situation where banks are not worrying much about the risks of mortgages. The value and the insurance cover any losses. We know what came of it, an unhealthy way of borrowing because the risks were not taken seriously. And insurers? They also were not dissatisfied. The housing insured itself by the rise since the year 1980.

Goldman Sachs was so smart to suggest that the insurance of such mortgages can be constructed into bonds with other investments. They put it in packets and gave it some value. If in anyway the insured mortgages claim their rights, then the increasing  of the value of the packets bond is still capable of taking the profit high. It was earning even more money on mortgages and the risks were placed in funds that were on paper 100% safe. You can statistically calculate something like that and therefore the correct ranking was AAA.

They were the guys from Goldman Sachs who devised this arrangement, but strangely, Goldman hardly contributes to this way of hedging risk. After a thorough inspection of the system, this largest bank on Wall Street decided that the risks of the system were too high.

And so it happened that Goldman Sachs stayed strong in the financial markets and came through the crisis wonderfully. Thus it happened that AIG (one of the largest insurers in the U.S.) had to pay 13 billion to Goldman Sachs because it had insured the rights. AIG was one of the companies for whom credit default swaps declined. The massive injection by the central government was in fact for a number of financial institutions insured by AIG that had put up the rights. So Goldman even got a stronger position.

It is clear that Goldman Sachs knew what was to come because with a number of hedge funds it managed to do the worst mortgage loans together in a package and then to speculate with shorts. It was the SEC on April 16 who began to research the background of the hedge fund Abacus, of Paulson & Co. The SEC (the financial market watcher) examined it for fraud. Last Thursday the SEC notified that they also were researching a fund by the name Hudson Mezzanine that collateralized debt obligation. It is the beginning of a bad time for Goldman. But there is more.

So now we know the story of the defective CDO (collateral dept obligations) in which some of the worst mortgages had been packaged. These products were made in the background at Timberwolf , and hedge fund Basis Yield Fund Alpha would have gone bankrupt in 2007. Weeks before the bankruptcy Goldman Sachs were praised for this fund because the CDO market had stabilized. There were good chances! Three weeks later, Basic was bankrupt.

Then there is the prosecutor of the State of New York who started an investigation of fraud in the sale of mortgages and the dubious activities of Goldman in the crisis with Greece. Goldman has knowingly participated in one of the largest fraud cases in the last 10 years. It is worthy to put it all on a tribunal but countries are not as fast to try for this sort of thing. But Goldman can, so be worried Goldman!

It seems all bad around Goldman Sachs. The almighty bank from Wall Street which everyone says is too big to fall, is under high tension. Is it payback time for Goldman and they know it?