As the big banks gear up to fight President Barack Obama's proposed "financial crisis responsibility fee," it's worth taking a look at some of the behavior that got us here. Dean Baker offers a great example—Goldman Sachs' bets against the financial products it was selling:
The basic story is that a [collateralized debt obligation, or CDO] is a pile of assets of different types. It can include parts of mortgage backed securities, parts of other types of securities and just about anything else that the issuer chooses. Goldman knows exactly what it threw into the CDO, the insurer (AIG in this case) only knows the information that is publicly available and what Goldman might chose to tell them.
When Goldman offers to buy a [credit default swap, or CDS] from AIG on its CDO, it is either throwing its money away, in the event the CDO is good or it is expecting to make money because it knows the CDO is bad. If you were AIG, what would you think? (btw, note that Goldman was not insuring an interest or "hedging" in any way. It sold the CDO, it didn't buy it, and therefore had no interest in it.)
Let me break this down for you. Too extend a metaphor that Phil Angelides, the chair of the Financial Crisis Inquiry Commission, used yesterday, think of Goldman as a used car salesman. Goldman knows there's a good chance that the cars it is selling are going to break down after 1,000 miles. But its customers have no easy way of figuring that out.
Here's the rub: in real life, a sketchy used car salesman can't take out an insurance policy that pays out if a car he's already sold breaks down. But that's effectively what Goldman can do with a CDS. It's the financial equivalent of buying homeowners' insurance on the house you just sold to your neighbors and then burning the house down.
So for Goldman Sachs, the best move was obvious: Sell as many lemony cars as possible, buy insurance on all of them (knowing they'll probably break down), and collect both the sale price of the car and the insurance payout!