Information Age: The Misguided Attack on Derivatives
After years of finger pointing for the housing bubble and credit crisis, from Washington to Wall Street and back, the upshot is this: a Securities and Exchange Commission complaint targeting one of the few people who realized the mortgage market would implode.</br></br>This is the surprising significance of the high-profile and complex complaint the agency filed earlier this month against Goldman Sachs for its work with hedge-fund trader John Paulson. The investment bank crafted securities that let him put his money where his analysis was, pointing to the housing boom as unsustainable.</br></br>One of the frequently asked questions about the housing bubble is why no one saw the problem until it blew up. The answer is that a few people did. Mr. Paulson, who was not charged in the SEC lawsuit, is chief among them.</br></br>Beginning in 2006, Mr. Paulson concluded that the end of the bubble was near. Goldman Sachs created special securities to facilitate trading, in this case synthetic collateralized debt obligations -- synthetic because this instrument didn't include mortgage-backed securities but was designed to move in line with them. Mr. Paulson thus communicated his wisdom to the market through these securities, which, far from undermining markets are best understood as an efficient information medium for resetting prices.</br></br>By analyzing the low quality of mortgages, he saw early the combination of easy money by the Federal Reserve, easy mortgages mandated by Congress, and what turned out to be too-easy math by Wall Street traders who failed to realize that this rare combination of factors would undermine their risk models. "It is easy to forget that before the collapse, the overwhelming view of investors, ratings agencies and economists was that the housing market was strong and would continue to get stronger," Mr. Paulson told his investors last week. He warned them in 2006 that he would start risking their money by shorting what he thought were bad mortgages.