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The recent news that the SEC (Securities and Exchange Commission) in the US is to sue Goldman Sachs could be just the start.

Goldman assisted hedge fund operator, Paulson & Co in creating a package of sub-prime mortgages for sale (known as a CDO). Paulson & Co were betting AGAINST this CDO, hoping to profit from a fall in its value. The SEC alleges that Goldman knew this and effectively misled investors by not disclosing.

According to the Wall Street Journal, this may not be the first case brought by the SEC:

“The SEC's case against Goldman Friday has exposed an open secret on Wall Street: As the housing market began to wobble a few years back, some big financial firms designed products aimed at allowing key clients, such as hedge funds, to bet on a sharp housing downturn…

“A critical part of the SEC's case against Goldman is that the firm allegedly misled investors by not notifying them of the role of hedge-fund investor John Paulson—who was dubious of the housing boom—in selecting what went into the mortgage deal Goldman sold. Goldman said it fully disclosed the investments and didn't need to reveal the Paulson connection.

“In the late stages of the housing boom, some hedge funds that doubted its staying power worked with banks to create CDOs that would provide them with a way to bet against the mortgage market. Often the hedge funds bought insurance-like contracts, called credit-default swaps, that would rise in value if the bonds, and thus the CDOs, weakened.”

What I find striking about this is that Paulson & Co have done nothing wrong; it was common practice to create a structure such as this CDO with the expectation it will go down, hope some other fool buys it, and then short it. However, Goldman are the only one being sued here.

I know a fund manager who in pretty much every presentation he gives likes to call hedge funds “blood suckers” or “the scum of the earth”. The fund manager specialises in working with companies who are in difficulty, helping to turn them around and profiting when the company recovers. This creates value, aiding the economy. Hedge funds, he argues, destroy value.