Recently the Securities and Exchange Commission filed a civil suit against Goldman Sachs for fraud and this sent its shares tumbling down. The debate has been raging surrounding the mega bank of Wall Street. Did Goldman Sachs violate the law? Or was the step taken by SEC backed by political interests?
Goldman is obliged to defend itself as the litigation is going to adversely affect its shareholders. But others are concerned with a far bigger issue than the legalities of the activities of Goldman.

Suppose it is legal. How does that serve the interest of the ordinary public? What is more potential is whether the lessons learnt from such activities, legal or not, can prevent a future rerun of the crisis the country has just experienced and not yet recovered from.

So the issue to be discussed is synthetic collateralized debt obligation or CDO. It is a financial tool of taxing complexity.

The first step is the granting of loans by lenders to borrowers keeping their property as security or collateral. In this particular instance it was the sub-prime borrowers who had poor credit record and in the true sense were not eligible for prime loans.

In the second step these loans were made into packets as mortgage backed bonds. The purchasers of these bonds get paid interest but they also have to take the risk of these loans defaulting because from the very beginning the credentials of the borrowers are in doubt.

In the third step these bonds together with others give the backing to a collateralized debt obligation comprising of a bundle of bonds. These CDOs are then peddled to investors who purchase them because they function like the usual bonds but carry far greater interest.

To create the CDO is required a credit default swap. The latter is insurance agreement with two faces. The first investor (short) agrees to give the interest of the CDO to the second investor (long). For this the long investor must compensate the short investor whole if the CDO underlying the deal defaults. Either of the investors does not have to actually hold the CDO. It is like synthetically purchasing one. The payments if it does not default and the costs if it does default are the same as if they really were the owners.

The main issue is how much the public benefited or suffered from such deals and not the fine legal points of right and wrong.

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