As you've no doubt read, the U.S. Securities and Exchange Commission charged Goldman Sachs with fraud last week, a move that caught big headlines around the world.

Although the case has potentially huge impacts on the business world -- and for green buildings -- reading the details about synthetic collateralized debt obligations (CDOs) are enough to make your eyes glaze over.

But the use of these CDOs, in this case one called Abacus 2007-AC1, has significant repercussions for Wall Street, so it's necessary to try to explain Abacus in clear (well, clearer) English. (For background, you can read the SEC complaint here in PDF format.)

Wall Street's use of instruments like Abacus has important impacts on its ability to supply capital to all economic sectors, including the renewable energy and energy efficiency industries. The use of synthetic CDOs has especially profound implications for real estate finance, including green and energy efficient properties, because the lion's share of real estate development and retrofit costs are borrowed, and Wall Street has played an increasingly important role in supplying real estate debt.

At the time of the Abacus deal, roughly one out of every four loan dollars for commercial and multifamily real estate came from Wall Street and the mortgage-backed securities market.

My own exposure to mortgage-backed securities and the subprime market began about seven years ago, when I was working for the Mortgage Bankers Association.  My responsibilities included covering the market for commercial mortgage-backed securities on behalf of MBA's members. Other colleagues covered the subprime market and the market for residential mortgage-backed securities.

It was an education. It took me a few months to sufficiently unravel the jargon so that I could follow the industry and communicate with MBA's Wall Street members. (OK, so I was a slow learner.)

My subprime "Aha!" moment -- it was probably in 2004 -- came when a colleague casually mentioned that some subprime mortgages were being written with adjustable interest rates and low or no documentation requirements. In other words, people with bad credit and limited incomes were being put into mortgages whose interest rates could go up, with little or no vetting by lenders. And the one thing that you could bet on in 2004 was that interest rates would go up, as they were then at near-historic lows. I was horrified at the loss potential for both lenders and homebuyers, and repeatedly told real estate industry friends that the subprime market was a train wreck waiting to happen.

I was also a slow learner because it did not occur to me that my subprime insight could be used to make big money in the securities market. (As I mentioned, I quaintly equated mortgage defaults with financial ruin, whether for borrowers or lenders.) But smarter minds on Wall Street had arrived at the same insight, and set about creating ways to bet against the coming subprime debacle. By 2007, Wall Street had even figured out a way to bet against the subprime market without needing to go the trouble of buying or selling subprime mortgages: the synthetic CDO.

Unlike a cash flow CDO, which contains real bonds, loans or mortgages, a synthetic CDO is made up of credit default swaps, essentially financial insurance policies that pay out in the event of default, whether or not the buyer owns the underlying bond, loan, mortgage or other financial asset.

Bluntly put, the synthetic CDO allows big money investors to place bets on a pool of mortgages by, in effect, buying or selling default insurance, whether or not they have an ownership interest in the underlying loans. But unlike the real insurance market, which is heavily regulated, there have been few rules imposed on the use of Wall Street default insurance (credit default swaps).

Which brings us back to Goldman Sachs and Abacus 2007-AC1. In effect, what Goldman did was to assemble a series of insurance policies that would pay off if specific pools of subprime (bad credit) and mid-prime (medium credit) mortgage  loans defaulted. In order to execute the insurance contract, "long" investors (who acted as insurers betting that the loans would perform) and "short" investors (in effect, policy holders who were betting that the loans would crater) were needed.

In fact, the Abacus transaction was initiated by the eventual "short" insurance policy holder, Paulson & Co., a hedge fund that stood to win big if the Abacus mortgages went under. Paulson paid Goldman $15 million to create Abacus, supplied Goldman with a list of mortgage pools on which insurance could be written, and participated in conversations concerning the selection of the mortgage loan pools whose default would trigger a payout.  (The SEC complaint alleges that Paulson suggested mortgage pools for Abacus that were characterized by heavy use of adjustable interest rates, low borrower credit scores, and housing located in markets where prices were escalating, all indicators pointing toward substantial defaults.)

According to the SEC, Paulson's conversations on pool selection took place with Goldman and ACA Management, the firm hired by Goldman to select the Abacus loans. The SEC complaint alleges that (1) ACA was unaware that Paulson would be betting against the pool and (2) ACA was misled by Goldman to believe that Paulson had a financial interest in the sound performance of the Abacus loans. ACA has not been charged with wrongdoing.

Next Page: More on Abacus.