Hedge funds: Who paid for their profits?
Goldman Sachs's results today will be a further opportunity for the world's most successful investment bank to respond to the civil fraud charge it has received from the US watchdog, the Securities and Exchange Commission.
Goldman is accused of creating an investment, a so-called collateralised debt obligation or CDO called Abacus 2007-ACI, so that a giant hedge fund, Paulson, could bet that the CDO would collapse in value, without telling those who bought into the CDO that they were the suckers on the end of this bet.
Goldman denies it has done anything wrong. And points out that those banks which lost money were sophisticated financial institutions which should have known what they were doing.
But apart from the potentially serious ramifications for Goldman, the case also shines a light on the behaviour of hedge funds during the euphoric years of 2006 and 2007 when the bubble in markets reached its peak.
Now it is important to point out that Paulson has not been charged with breaking any rules or laws.
But its behaviour in this deal - and the actions of other hedge funds in similar deals - may increase the determination of politicians, especially in Europe, to curb hedge funds' activities.
Because what Paulson and other hedge funds did in these boom years was not simply to bet on a slide in the value of investments that already existed and were being traded.
These hedge funds encouraged investment banks to create brand new collateralised debt obligations to be sold to other banks and investors - so that they, the hedge funds, could then speculate that the price of these CDOs would shrivel.
Both Goldman and the SEC agree this is what happened in the Abacus 2007-ACI case.
Why does this matter?
Well it means that the hedge funds were - for example - spurring the investment banks to manufacture these CDOs, which bundle together other securities made out of low quality or sub-prime loans to home buyers. And the effect may have been to increase the supply of cheap finance to homebuyers.
In other words, the hedge funds can be seen as having pumped up America's unsustainable housing bubble with the intent of maximising their winnings as and when that housing bubble burst.
In some cases, hedge funds - though not Paulson in the Goldman case - are said to have provided risky equity, the essential ingredient to allow the collateralised debt obligations to be created, and then took out insurance against the risk of default on the very same CDOs.
The allegation is that they put up money knowing that it could be lost, so that they could then make even more money from the insurance claim when the investment went belly up.
A number of hedge funds made billions of dollars in 2007 and 2008 having astutely placed bets that investments made out of US sub-prime housing loans would collapse in value.
Now, if this was their reward for pointing out that - in an investment sense - the emperor had no clothes, who could quibble with that?
And if - prior to that - they encouraged investment bankers to sell CDOs to gullible professional investors, thus perpetuating the myth for a convenient period that the emperor was magnificently attired, weren't they just being entrepreneurial?
On that view, today's moans about how some hedge funds profited at the expense of these gullible investors is surely just the sour grapes of the foolish against the smart.
Except that it wasn't just deep-pocketed professional investors - banks and insurers - who were on the other side of the hedge funds' bets. When the hedge funds picked up their winnings, it turned out that some of these banks and insurers didn't have the moolah. And the bill landed on taxpayers' doorstep.
To put it another way, the painful flip side of hedge funds' huge profits from betting on the collapse of sub-prime was billions of dollars of losses for banks and insurers. These losses were a major contributor to the meltdown of the banking system in 2007 and 2008 - which in turn led to a global recession and the biggest taxpayer bailout of banks that the world has ever seen.
Some will argue therefore that what a few hedge funds did was not an example of markets doing what they do best, which is to allocate resources to where they can be used most efficiently.
Instead hedge fund critics will see it as a justification for imposing significant new constraints on how hedge funds operate, on the basis that the billions of dollars in profits they made were not blameless profits.
Or to put it another way, the determined manner by which some hedge funds maximised their riches may have contributed to the impoverishment of the rest of us.