the notional CDO forms the basis for a thought experiment: Given any performance scenario for debt in the reference portfolio, we can compute the loss that would have been experienced by holders of the various tranches. So, we could write a kind of swap (somewhat different from an ordinary credit default swap), whereunder a "protection buyer" pays a predetermined, fixed spread and a protection seller pays the losses that a hypothetical holder of a tranche in the notional CDO would have experienced.
My initial reaction to the Goldman lawsuit was that the nature of the transaction was beyond my depth. Reading Waldman's post confirms this.
Incidentally, I am not stupid. Nor do I lack a background in finance. Among other things, I have read Marcia Stigum's treatise on money markets, worked through Robert Merton's lecture notes from his graduate course, and read Robert McDonald's graduate textbook on derivatives. And I have close to no idea what Waldman is talking about.
But I put it to you that this transaction was part of a financial ecosystem that did not create value for the rest of the economy. Rather, it developed initially to create regulatory capital arbitrage, meeting the demand for AAA-rated securities created by simplistic, world-wide bank capital regulations under the Basel Accords. Starting from this central purpose, the structured transactions industry evolved to the point where deals like the Goldman Abacus "security" were created.
And this is the financial system that Ben Bernanke and Henry Paulson are credited with saving. My question is, why was it so important to save this system?
I had a relative who suffered from severe mental illness for many years. One day in despair, she jumped off a bridge into a river. A bystander dove in to attempt to save her, but it was too late.
It seems to me that Wall Street suffered from mental illness in recent years, and the financial crisis was its attempt to commit suicide by jumping off a bridge. Bernanke and Paulson tried to save Wall Street by throwing the taxpayers into the river.
I appreciate what the bystander did for my relative--he was trying to save a woman's life, at some risk and discomfort to himself. But in the case of Wall Street, I do not think that the mentally ill financial system should have been saved from its suicidal impulses.