Goldman stood to profit from several aspects of California's borrowing, which involves the sale of bonds to investors. First, it collected millions of dollars in fees for bringing the bonds to market and finding buyers. Then it marketed a financial instrument known as a credit default swap that is essentially an insurance policy against a bond default.
The bond investor buying the instrument pays a fee in exchange for a promise of a full refund of the bond's face value should a state such as California abruptly refuse to pay back what it owes. Such defaults are extremely rare -- California, for example, has never defaulted -- but the swaps' prices rise as states or municipalities slide into tough times economically.
Goldman, according to sources familiar with municipal bond trading, has been a leading dealer in municipal credit default swaps. The New York-based firm was trying to expand that niche market into one with broader appeal to major investors.
The company also is an important underwriter of California municipal securities. Over the last five years, it has earned about $25 million in underwriting fees from California issues.
The 58-page document advised big investors how they could profit from -- or hedge against losses in -- financial markets that had become extremely volatile and unpredictable. The firm advised "shorting" -- that is, betting on a price decline -- in markets for corporate junk bonds, European banks, the euro and British pound currencies, and U.S. municipal bonds.
Several large states, including California, faced "worsening fiscal outlooks," the report said. It cited the recent bankruptcy of the Bay Area city of Vallejo as evidence of the "worsening fundamentals of municipal finances."
Meanwhile, muni bond insurers were suffering credit downgrades, it noted, which undermined the quality, and therefore the prices, of the bonds they had insured. And the credit crunch was forcing big investors such as hedge funds to dump their muni bond portfolios, driving down the bonds' prices.
Goldman recommended making the short bets via credit default swaps, a market in which it played a major role.
These instruments are designed to allow investors and speculators to hedge, or insure against, the risk that bond issuers or other debtors might default on their obligations. In their customary form, they are contracts that require their sellers -- in this case Goldman Sachs -- to buy back from a swap holder a defaulted bond at 100 cents on the dollar, thus insuring against any loss.
