I watched the Charlie Rose interview of Loyd Blankfein that I had dvr’d tonight. He is an extremely well spoken intelligent guy. He explained what hedge funds do in the simplest, most straight-forward way I’ve ever heard. He explained the market need for companies to be able to hedge risks in order to be able to take risks. He explained it by saying, “If I’m trying to finance an offshore oil well, well that oil well may work if oil is trading at $80…a barrel. But if it comes out at $40 a barrel I’ll go bankrupt. So noone will give me financing unless what? Unless I can lock in the price of oil at $80 a barrel. So I’m gonna go to Goldman Sachs and say, I would like to sell oil forward at $80 a barrel. Is that person betting on the price of oil? I guess you could say that. But what is that person really doing? They are hedging a risk that will allow that company to go out and invest $10 billion in extracting oil out of the market. That person is selling oil, but as a result of selling oil forward, what does the world get? It gets more oil.” (Go to Charlie Rose and fast forward to the 48:30 mark)
The explanation is simple and very helpful in understanding what hedge funds do. However, the analogy for hedging the price of oil does not accurately describe the role Goldman Sachs took in developing and selling CDOs for the subprime mortgage market. In order for the analogy to be accurate, Blankfein would have to state that Goldman Sachs knew the grade of oil from the well was going to be low but they gamed the ratings agencies into listing the potential oil grade as being really high in order to hedge the $80 per barrel price. Seems to me that is being unethical.