This post first appeared in the May edition of: Cirios Trends: In Search of Real Estate Opportunities.

Over the past several weeks, the federal government’s increased scrutiny of Goldman Sachs has brought complex financial securities at the heart of the housing market collapse back into the government’s crosshairs. We thought an attempted explanation of not just the case against Goldman Sachs, but of how these instruments in question, CDOs, actually work would be valuable.

On April 16th, the Secuities and Exchange Commission, or SEC, filed a civil suit against Goldman Sachs, and late last week it surfaced that the Justice Department was conducting a criminal investigation into the company’s trading practices.

Both departments are focusing on Goldman’s involvement in setting up collateralized debt obligations, or CDOs. The charge, and one that on the surface sounds like a slam dunk for the folks at the SEC, is that Goldman colluded with a hedge fund to create a security designed to fail, then peddled it to unsuspecting investors while the hedge fund placed huge bets the security would fall in value.

During the boom, investment banks like Goldman Sachs bought up thousands of individual mortgages and packaged them into mortgage back securities. These securities aggregated monthly cash flow payments from individual borrowers, then distributed them to investors based on their risk tolerances. Risk-averse investors (pension funds, big banks, insurance companies, etc) were paid first while more risk hungry investors like hedge funds, were paid second if there was enough money left after the first group was paid.

For taking on the risk of being paid second, investors were paid a higher rate of return.

CDOs function similarly, but rather than aggregating individual mortgages, they group together mortgage-backed securities (stay with us).

CDOs aggregate the payments of individual securities, whose cash flow is determined by the mortgages that make up each one. Investors in the CDO get in line for payments and are compensated based on their place in line for cash flows.

The Goldman security in question, called Abacus, takes this one step further. Abacus was hatched using a collection of what are known as credit default swaps, or CDS, and is thus known as a “Synthetic CDO.”

CDS, for all their complications, are nothing more than insurance policies. Let’s say you own GE bonds, and even though GE is a solid company, you’re a little nervous GE may run into trouble and not be able to pay back its bondholders. To alleviate this concern, you could buy a CDS that guaranteed your investment in the event GE couldn’t make good on its bond payments. The seller of that CDS (think insurance company) only has to pay if GE stops making its payments. So, if news were to break that GE were running out of cash, the insurance would go up in cost (value) since bond holder protection would be in high demand.

An investor in a synthetic CDO is paid from premiums collected from CDS buyers who want to bet that the securities protected by the CDS default, thereby increasing the value of their investments in the CDS (get all that?).

So, here you have two sides of the trade. Synthetic CDO buyers hoping the underlying securities keep paying and that CDS buyers keep paying their premiums vs. CDS buyers who hope the underlying securities fail, thereby pushing up the value of their protection.

Since CDS contracts do not require that the insurance seller (or buyer) own any of the underlying securities, these devices were essentially high risk gambling devices, where many gamblers made large sums of money at the expense of other gamblers. Clear as mud, right? It’s easy to see how these often opaque securities got out of control.

At issue is if Goldman, as issuer of the security, made proper disclosures to buyers about the nature of the security and who designed it.

And while it’s easy to cast the case in the “Evil Wall Street Greed” category, investors too deserve their share of the blame for blindly buying what they were told was good quality.

What ever happened to Caveat Emptor?