Back to Goldman. In the early '90s, I recall, Collateralized Debt Obligations or "CDOs" were taking off on the continuation of mortgage bond market pioneered by Lewie Ranieri the mighty First Boston in 1987 or '88. Back then, "jumbos" and "subprime" strange words but not evil. CDOs are, in theory, an investment-grade security backed up by a 'pool' of low-risk bonds or loans or other assets of different maturities and credit quality. The pool generates cashflows from principal and interest payments, which can be chopped (or tranched) allowing investors various exposures to different risks and returns. The originator, like bank or thrift, could efficiently move the asset, such as a mortgage, from its balance sheet reducing the need to reserve cash to offset a possible default. This new market offered unheard of liquidity benefitting companies and home-owners alike.
By the 90s, hot shot traders realised CDOs highly unlikely to fail as the underlying issuer companies like GE. Triple A, dude. Still, defaults could happen and banks wanted insurance - enter credit default swaps. A CDS guarantees a credit on the issuer so, for instance, should GE fail the owner of a CDS still receives his payments. CDS sellers earn a premium with little worry (they thought) of a default-inducing-payout; and they issued these securities with no money down. In short, the ultimate ATM until, that is, the crash. Firms like Bear Stearns and Merrill Lynch made billions issuing and trading CDSs. Commercial banks, for their part, sold and bought CDSs so when the the musical chairs stopped, they owned a net position. Pure sellers, like AIG, were caught unawares once the liabilities crystalised - this amounted to hundreds of billions of dollars they did not have.
So now it gets tricky. By '07, CDOs were mostly a cash market, ie, backed by principal and interest payments from the collateral (bonds). By '07, over 80% of CDOs synthetic. In a synthetic CDO, the bank holds a portion of the reference portfolio (the "stump") instead of selling it off to investors. With a cash CDO, banks transfer the risk to another party through the sale of the assets; however, in a synthetic CDO, banks keep the assets on their balance sheet and purchase protection through a CDS to transfer the risk away to another party. Banks do this today to manage their cash position - it is a "hedge." In the unlikely event the SEC decides that CDS a ponzi scheme and declares them illegal, a large chunk of your banks balance sheet will vaporise.
So why did AIG not protect itself and how is Goldman somehow involved? AIG believed a CDS like any insurance policy where a payout event, like death, non-correlated. My dying has little baring on your dying, for example. Bonds are different: if a bond fails, other, similar, bonds are highly likely to fail.. and their risk of failure becomes exponential. The first defaults in '08 triggered an avalanche of destruction for most, excluding .. Goldman Sachs. As Gretchen Morgenson at the NYTs noted, Goldman, and no other Wall Street firm, was involved in the AIG rescue talks and an AIG failure would have created a hole as big as $20 billion on Goldman's balance sheet as they purchased CDSs from AIG. Instead, they were made whole while Lehman Bros., also sellers of CDSs like AIG, allowed to collapse. Goldman also made money with Paulson & Co on CDS by allowing Paulson, the counter-party, to assist in the creation of a portfolio that Goldman marketed to its clients without informing them Paulson (A) helped construct the portfolio and (B) was shorting it. More will come out.
Back to Goldman. In the early '90s, I recall, Collateralized Debt Obligations or "CDOs" were taking off on the continuation of mortgage bond market pioneered by Lewie Ranieri the mighty First Boston in 1987 or '88. Back then, "jumbos" and "subprime" strange words but not evil. CDOs are, in theory, an investment-grade security backed up by a 'pool' of low-risk bonds or loans or other assets of different maturities and credit quality. The pool generates cashflows from principal and interest payments, which can be chopped (or tranched) allowing investors various exposures to different risks and returns. The originator, like bank or thrift, could efficiently move the asset, such as a mortgage, from its balance sheet reducing the need to reserve cash to offset a possible default. This new market offered unheard of liquidity benefitting companies and home-owners alike.