The Goldman Abacus Fund:
Ethics You Can Count On
Ethics That Don’t Add Up
Imagine a physician is on the golf course with one of his colleagues, who happens to be a cardiologist. Somewhere on the back nine the cardiologist begins to tell the physician about one of his patients, a 52 year old man with blood pressure of 145/99, who is 40 lbs. overweight, chain smokes, and enjoys 7 to 8 martinis a day. In spite of medications, in the words of the cardiologist, the patient is “a ticking time bomb.” The first physician asks for his friend’s patient’s personal information, and after the golf game, goes to see his State farm agent, where he takes out a 1 million dollar life insurance policy on the ‘time bomb” guy. Are the actions of the physician ethical? Taking out such a policy is of course illegal, as the doctor does not have what is known as an insurable interest. But assuming the doctor took no steps to encourage the man’s death, under the theory of rational egoism his actions would be justified. Furthermore, as macabre as the doctor might seem in betting on the death of another human being, Sternberg would consider his actions to be within the realm of ordinary decency.
In 2007, amid historic economic development, a scenario emerged similar to the one just described. Although the players and events were quite different, the same philosophical question was raised: is it ethical to benefit from someone else’s demise. Living in a society riddled with envy and resentment, many onlookers thought so. Two parties in particular did not. They were John Paulson & Co., a hedge fund company established in 1994, and Goldman Sachs & Co., a global investment banking and securities firm founded in 1869.
The story has its beginnings in 2005 when 49 year old Paulson, a man with a Wall Street reputation of mediocrity, hired an out of work analyst, Paolo Pellegrini. Pellegrini’s job was to crunch numbers on a befuddling trend which “everyone” seemed to be making money on except Paulson (Zuckerman). After a year’s worth of late nights, Pellegrini determined that not only were housing prices soaring independently of interest rates and well beyond the pace of inflation, but that when the bubble did pop, it would send home prices down more than 40%. When Pellegrini showed his charts and figures, Paulson couldn’t believe his eyes. Finally the housing market boom made sense to him. What also made sense to him was the market’s inevitable crash. Paulson had to find a way to make money on this prediction. Initially Paulson and Co. bought large lots of credit default swaps, which in effect were insurance policies against “risky” subprime mortgage debt (Zuckerman). Paulson was paying up to an 8% premium to guarantee against the default of mortgages he didn’t even own. Paulson and Co. spent months accumulating these mortgage insurance policies before deciding that the process was too slow. Paulson needed another way to short the housing market, preferably one with great leverage. A collateralized debt obligation seemed to be the perfect means to Paulson’s desired end.
To understand how Paulson was able to make a $15 billion profit on his market prediction, a closer look at the 3 main financial instruments used is needed. Residential Mortgage Backed Securities (RMBS), Collateralized Debt Obligations, and Credit Default Swaps are all financial instruments used by both commercial and investment banks. RBMSs are bonds which are backed by a pool of residential mortgages. These bonds have different ratings based on the default risk of the varied prime and subprime mortgages. Even though the initiating bank may continue to service the loan to the homeowner, the mortgage itself will likely end up being sold again and again, often being pooled as an asset base to compose a RMBS....
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