In one such casino operation, a U.S. investment bank would sell one or several gamblers (e.g., in hedge funds or other banks) credit insurance policies on a batch of specified bonds with a face (redemption) value of, say, $1 billion. These insurance contracts are known as Credit Default Swaps, or CDSs. The buyer of the CDS did not need to own any of these bonds. They were merely used as “reference bonds” on which to place a bet — like buying fire insurance on someone else’s house.
If subsequently some of the reference bonds in the batch defaulted, then the bank that had sold the CDS would have to pay the buyer of the CDS (the hedge fund) the full face value of the defaulting bonds.
In return for that insurance, the buyer of the CDS (the hedge fund) would pay the seller monthly insurance premiums. These buyers bet and hoped, of course, that a default would happen. They would then get a ton of money in return for only a small insurance premium.
To offload their risk of selling the insurance, the U.S. bank would bundle all of the insurance premiums from the CDSs on the reference batch of bonds and resell this bundled premium cash flow in the form of so-called Synthetic Collateralized Debt Obligations to other investors. The latter would then be responsible for paying any insurance claims against the reference batch in case of default. They bet, of course, that none of the bonds in the reference batch would default and that they would get the premiums without ever having to pay an insurance claim.
As I understand it, the government now contends that Goldman Sachs has not always played fair with both parties in this casino operation.
Absent any inside information, if I had to bet now, I’d wager that the criminal charges against Goldman will not stick. But one never knows. Perhaps the prosecutors will ride away into the sunset after Goldman pays a settlement of $1 billion or a few billion. And perhaps Wall Street’s casinos already trade a new derivative based on the outcome of the case.
Oh, yes! And where did the $21 billion of Goldman market value go? First, ask some seniors, if only to torture them. If they don’t know, visit my New York Times blog.
Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor in the Wilson School. He can be reached at reinhard@princeton.edu.
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