Goldman Sachs' Potentially Profitable, and Potentially Dangerous, New Business

"This is one of those points when it helps to see capital as an agent, a force in its own right. ... Capital wants to grow. ... If the old formulas aren't working, money will seek new formulas."
-- John Lanchester, I.O.U.: Why Everyone Owes Everyone and No One Can Pay

For Goldman Sachs (NYS: GS) , one of those tried-and-true money-making formulas may be about to disappear -- the Volcker Rule will soon abolish investment banks' ability to trade for their own accounts. If a job ad on the Goldman website is to be believed, the company may be seeking to replace some of the consequent lost income with a move into "monoline insurance." Here's the scoop on what the bank everyone loves to hate is up to, and why investors -- and the rest of the world -- need to beware.

Monoline what?
A monoline insurance company provides guarantees -- that is, insurance -- to bond issuers for the purpose of enhancing the credit rating of the bonds. The insurance on the bond makes it seem more secure, and therefore more attractive, to investors. This insurance is called a "credit wrap."

It used to be that credit wraps were used only for municipal bonds, but now they're also used for the types of bonds that became infamous at the height of the financial crisis, such as mortgage-backed securities and collateralized debt obligations.

The naked and the damned
Per the job ad, Goldman's new VP-level employee will "meet with clients and build up this [monoline] business." The bank adds that "part of the reason this is a potentially interesting opportunity is that the monolines are bust or close to bust." What the ad doesn't say is why.

Credit wraps, or "financial guarantees" as Goldman refers to them, are derivatives and are just shy of being full-on credit default swaps -- those other infamous leftovers from the financial crisis. Goldman even describes the product as "like a credit default swap ... but with two key differences: (a) it's against a particular financial instrument rather than an entity; (b) you can only purchase the policy if you have an insurable interest. In other words, there are no 'naked shorts' with an FG."

Naked shorting refers to the practice in the swaps world of taking out a policy on something you don't own or have an insurable interest in. It's like buying fire insurance on your neighbor's house: If it doesn't burn down, you're out your premium. If it does burn down, you collect a big payout. It changes the policy from being insurance to being a bet. Monolines like AIG (NYS: AIG) went bust because of gross overexposure in the largely naked-swaps world that played such a big role in the onset of the financial crisis.

All derivatives are not created equal
The European Union recently banned naked credit default swaps in sovereign debt. In the U.S., varying degrees and methods of swaps regulation are currently being worked out. And now the Volcker Rule is intended to wipe out investment banks' trading for their own accounts. But capital, as we know, wants to grow and will always find new ways to do it.

The monoline insurance business is one of those ways to grow capital and, given that it's done properly, could be a reasonable way to do it. Derivatives aren't automatically evil. It was uncollateralized credit wraps that got the monoline insurance business into trouble during the crisis. Goldman steered clear of monoline losses by working with AIG, which posted collateral against its credit wraps.

Theoretically, Goldman could be able to steer clear of trouble. The monoline bust and limits on naked credit default swaps could mean less competition for the monoline insurance business, while allowing Goldman to operate in Europe -- a financial market with no shortage of bonds to wrap.

Goldman can set a good example
Post-crash, there are only two U.S. investment banks of note (read: too big to fail) left standing: Goldman and Morgan Stanley (NYS: MS) . JPMorgan Chase (NYS: JPM) , which bought up failed Bear Stearns, and Bank of America (NYS: BAC) , which bought up Merrill Lynch before it could fail, always had a commercial side to lean on if, because of regulation, investment banking becomes significantly less profitable. But Goldman and Morgan Stanley are all in on the trading side, and have to make money whenever and wherever they can.

But given the terrible history of investment banks and derivatives in the past few years, and the lack of any serious swaps regulation so far in the U.S., Goldman must tread very carefully here. The great vampire squid is run by very smart people, but so were Lehman Brothers and Bear Stearns. For its own sake, for the sake of its investors, and for the sake of markets everywhere, Goldman needs to get this right.

Maybe Goldman could set an example of how to do derivatives safely and responsibly. It would be a nice change of pace, delivering the storied investment bank some good PR in a time when it's awash in nothing but bad. At this point you may be ready to hear about a bank investment a little less mind-bending than the great and powerful Goldman. If so, you can learn about some delightfully straightforward bank stocks, including one Warren Buffett could have loved in his earlier years, in our free report, "The Stocks Only the Smartest Investors Are Buying." Download your copy while it's still available.

At the time thisarticle was published Fool contributor John Grgurich is aiming to become too big to fail, so the government will bail him out no matter how many stupid financial decisions he makes, but he own no shares of any of the companies mentioned in this column. Follow John's dispatches from the bloody front lines of capitalism on Twitter, where he goes by @TMFGrgurich. The Motley Fool owns shares of Bank of America and JPMorgan Chase.Motley Fool newsletter serviceshave recommended buying shares of Goldman Sachs. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days. The Motley Fool has adisclosure policy.

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