I get that Goldman Sachs hired the hedge fund manager John Paulson to pick shit investments that were sure to fail, I get that Goldman Sachs then bundled those together and sold them to investors citing an independent 3rd party organizer. I get that Goldman Sachs then secretly made bets against those very packages (Abacus 2007-AC1 and the like) assured that they would fail.
I just don’t get how you bet on something to fail and make money.
For Wiki:
I just don’t get it.
The essence of short selling is quite simple. Suppose that currently, widgets are selling for $15. I think that they’re overpriced and the price is due to fall. So I find somebody who thinks that they’re a good deal(say it’s you) and make a contract with you. The contract says that I will sell you a widget on April 30 for the price of $14. The key is, I don’t actually own any widgets right now. On April 30, I’m going to buy a widget and sell it to you. If the price of widgets falls to $10 by April 30, I make a $4 profit. If the price of widgets rises(or even stays constant) I lose money, and you got a good deal on a widget.
Short-selling step-by-step:
That’s the simplest form of betting against a security – a short sale. There are other forms, such as put option contracts, which are derivatives that gain value when the underlying security loses value, and even more complex arrangements, all of which are sometimes referred to as shorting strategies even when they might not actually involve short sales.
Rysto, yes you did capture the ‘essence’ of the short sale with your description but I believe that there is a subtle difference. Your description sounds more like an option contract with a strike price and expiration date which is a completely different animal.
Following your example… you would borrow some widgets from a third party and sell them immediately on the open market for $15 each. At some point in the future you would choose to buy widgets on the open market to repay that third party. If you were correct and the price of widgets is lower you can keep the difference less any fees assessed by the lender of the original widgets. Conversely if the price of widgets goes up you would lose money on your short position.
No, that’s an option.
A short sale of securities requires you to actually physically locate what you’re trying to short as there is no counter-party (unlike an option contract).
That’s really a derivative, not a straight short-sale. What you describe could be a put option with a strike price of $14.
Unless you’re a big bank, in which case you didn’t actually need to locate any securities available for borrowing, known as naked short selling.
Likewise, it’s easy for Goldman to write a derivative that’s based on a security even if they don’t own the security. For instance, they could enter into a contract where Goldman receives a fixed cash payment, and in exchange they pay out the return on a (junky) MBS or CDO tranche; then when the MBS or tranche becomes worthless, they profit (no more payments to make).
It’s just like insurance.
It IS insurance.
When I buy a life insurance policy, I’m betting the insurance company that I am going to die tomorrow. They are betting I won’t. If I win, they pay me (actually my heirs) money. If they win, I pay them money, in the form of premiums.
GS was insuring their loans. Whether or not they did so legally or wisely is beyond my competence, but there is nothing per se odd about their doing so.
But is that what it really was?
From this news story:
Your life insurance analogy is not an exact match because the product ‘life insurance on myself’ is fixed. It would be a better analogy if GS sold life insurance on people in your town. The question would be did GS cho0se particularly healthy or unhealthy people? And did they misrepresent to their customers the health of the people for whom they were offering life insurance? And if an unusual percentage of people that they offered insurance for suddenly died, it would warrant a closer look to see if GS acted illegally.
It is reasonable for a company to insure itself against extreme failure. But if a company positions itself to make a significant profit if the products that it sold fail, then it is reasonable to take a closer look. It suggests the possibility that they knowingly sold a bad product in order for their ‘insurance plan’ to succeed.
Not true. The distinction between insurance and gambling is that in gambling, you have the option of cutting your losses by not playing the game. You’re going to die whether you have life insurance or not; the difference is whether you’re willing to trade some money now for more money when that happens.
Insurance agents must love you.
Keep in mind that derivatives are a zero sum game. One person makes $1 and the other party loses a $1. It’s that simple.
In Goldman’s case, there were investors that thought property values would keep going up and bought a contract that reflected that. At the same time, the Paulson group thought properties were going to go down, and bought the other side of that same contract. Goldman was the middle man matching the bulls and the bears. One wins and one loses.
In this case, Paulson’s group is the one that selected the products that the derivatives contract would be based on. That is a clear conflict of interest, if not outright fraud as the buyers did not know this.
Question:
Suppose I short a stock that is later worthless because of bankruptcy like Global Crossing a few years back. The stock is unavailable because it now doesn’t exist and the certificates are literally worth 0 cents. Is the transaction over (and I made a ton of $) or do I still need to buy the stock back at a nominal cost like $0.01?
How about this for an analogy. A firm puts together a fund that buys tickets for horse races, but just bets on the horse with the highest odds because they notice that over time it has a positive return; i.e., even though you lose some races you win enough other ones to make up for it.
But, the person who sets the odds works for the firm selling the fund. They lie to you and say that the horses they are betting on have better odds than they actually should. Then, knowing that the odds for the long-shots are actually better than they should be given what they told you, they buy tickets for the long-shots with some of the money they took from you to manage the fund. So they are using their money to bet on different results than they advised you to do.
You don’t need to cover (or you cover at $0) if the company goes bankrupt. This is assuming that the common shareholders aren’t entitled to any of the firm’s assets, which they never are. If the shareholders did get something, you’d owe it to the person whose shares you borrowed, much like if a dividend payment occurred while you held the shares. (This last part is a guess.)
Goldman made money on the transaction commissions and the 15 million dollar fee it charged Paulson to set up the investment vehicle.
Here’s some background
Let me try a different explanation. In this case it’s not ‘selling short,’ which is probably what is confusing.
Think of it like this -
you want to bet a lot of money for team A to win the Super Bowl. So you make a contract with Goldman that if team A wins, you’ll get $98. Goldman turns around and finds someone that wants to bet on team B. So Goldman has a legal enforceable contract with you
Goldman has a legal enforceable contract with the other guy. You both bet $100. If you win, you will get $98, the other guy pays $100 (Goldman gets $2 for setting everything up).
Neither of you ‘own’ anything except for the one way contract with Goldman.
Is this clear? The concept is this basic.
Paulson went to Goldman and said ‘set up the bet with suckers that want team A because I have inside information that the entire backfield and head coach will be arrested the night before the Super Bowl and won’t be able to play. And lets pay a supreme court justice to give his ‘free and unbiased opinion’ that it’s an evenly matched set of teams, nothing will interfere with a fair game and the best team winning.’
Yeah… but … in this case it’s important to designate that “inside info” in a ball game and real “inside info” in picking stocks are very different things. And it’s extremely illegal to bet using “inside info” in making stock plays. Better to just say he thinks the team he’s betting against is going to run out of gas.
Want to reform Wall Street? Start by declaring GS a criminal enterprise guilty of economic terrorism.