The product at the heart of the US Securities and Exchange Commission's civil charges against Goldman Sachs is a synthetic collateralised debt obligation. This complex structure comprises a bet from a set of “long” investors that a given pool of mortgage-backed bonds will pay off; and another from a set of “short” investors who believe it will default. The CDO simply reconciles these opposing bets, much as a bookmaker would.
The structure issues both bonds and insurance. The bonds, secured against financial insurance contracts (credit default swaps) taken out against the pool of mortgage bonds on which investors wish to bet, are sold to long investors. The short investors, who believe the bonds in the pool will fail, buy the insurance. Their premiums pay the long investors' coupons. In return, the long investors' principal payments for the bonds are set aside to cover insurance claims in the event of a default.
To assemble and sell a synthetic CDO such as Goldman's Abacus, an investment bank must co-ordinate counterparties and agents carefully – not least because it must reconcile two opposing views of the market without spooking either side.