Goldman, SEC & the Making of a Meltdown

The financial media is buzzing about the lawsuit that the Security and Exchange Commission recently filed against giant investment bank Goldman Sachs (Stock Quote: GS). You’re probably thinking, “what does that matter to me? I don’t have any money with Goldman Sachs.”

Well, this lawsuit isn’t about one bank breaking an obscure rule. In fact, it gets to the heart of the financial meltdown and the bailouts that followed. You know, the bailouts that you paid for with your tax dollars?

Wall Street types sometimes like to say that they didn’t see the financial crisis coming. That it took them by surprise. For some people, maybe that’s true. But for others, not only did they see it coming, but they stood to make big money when it did. That’s what this story is about.

Here’s what’s going on.

First some background. Before the Great Recession, if you wanted a home loan, you could get one even though you might not have the best credit score or a large down payment. In fact, many banks were giving mortgages to just about anyone. Why were banks doing this? Some say banks thought real estate would always be increasing in value, so even if they were making risky loans, they couldn’t lose because the properties would ultimately be worth more than the value of the mortgage.

But there’s another reason why banks were giving mortgages out to anyone and everyone, and it’s that reason that gets at the heart of the SEC’s lawsuit against Goldman.

Many of the mortgages were bundled into investment packages that people and companies could buy shares of. You may have heard the term “collateralized debt obligations” tossed around, and these investments are what this term refers to (we’ll call them “mortgage funds” just to keep things simple).

Some mortgage funds were considered safe . These were the ones filled with mortgages taken out by people who could likely afford to pay off the loan. But there were also mortgage funds that were considered not so safe. These were filled with risky loans given to people who were likely to have trouble paying the balance. These are generally called sub-prime mortgages. The mortgage funds that were filled with sub-prime loans had a higher rate of return for investors.

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