[jyl]

I'm not an expert on this stuff but here's the short version.

Neither Paulson nor Goldman invented mortgage backed securities. There were lots of MBS before the Abacus deal.

Paulson wanted to short the US housing market. He got Goldman to put together a MBS backed by pools of mortgages that he, Paulson, helped select. He chose those pools that he felt were most likely to decline in value.

Goldman packaged these as the so-called Abacus deal and sold them to large, supposedly sophisticated, institutional investors. Just another of the many MBS deals that were being done at the time.

Paulson took a short position on some part of the Abacus MBS, presumably with credit default swaps (CDS) though I haven't read exactly what tool he used.

The housing market blew up and Paulson made a lot of money, the investors who bought the Abacus MBS lost a lot of money. Goldman got their fee.

As it turns out, Paulson could probably have shorted any MBS and made the same profit, because the whole market blew up. Presumably the collapse was much greater than he expected at the time, otherwise he wouldn't have bothered to get Goldman to put together this specific MBS.

The investors who bought Abacus were big banks and other large institutions. They lost lots of money, on all sorts of assets of which Abacus was a small part.

Paulson's investors, who were probably a mix of wealthy individuals and other institutional investors, made a lot of money on shorting Abacus. So did Paulson.

Separately, by the way, Goldman held MBS as part of their own assets. At some point they became concerned about the housing market too, and shorted the market with CDS. This hedged their portfolio so that their direct losses from the MBS collapse were largely offset by profits on the short postion, and their net loss on MBS was much smaller than suffered by other banks. They lost plenty of money even so, though, because all assets fell hard in value, not just MBS. I don't know if they invested directly in Abacus.

Basically, in the micro view, this was a deal done between big boys, all of whom knew they were taking risks, could win or lose big, and were being well-paid to make the correct bet.

In the macro view, the losses inflicted by Abacus on the investing banks were one more thing among many that drove some of them to near insolvency, which was one more thing among many that drove the global financial system to near collapse in 2008, which was the main thing that forced governments around the world to take desperate and dramatic measures to stave off a second Great Depression. Those measures succeeded - the financial system did not collapse and we had a "Great Recession" which is at least better than a Great Depression.

The people doing the deal probably had no idea how dramatic events would be or that they would be helping to drive the financial system to the brink. I'd say it wasn't their job to care. The point of capitalism is that individuals act purely in their own financial self-interest, while appropriate laws and regulations constrain the behaviour that would be most harmful to the country as a whole.

The MBS market was not heavily regulated at the time. The trend for the past few decades had been to de-regulate the financial system and let market forces work. So I doubt that the structure of the Abacus deal was illegal in any manner. Whether Goldman committed any fraud in selling the Abacus deal, I don't know. I don't think a salesman has to actually believe in the product that he sells, but I suppose he can't factually misrepresent, and whether they crossed that line is unknown (to me).