A good recap from US News:
"...That's what happened in the Goldman deal, which was created using a package comprised of various credit default swaps. Investors like Paulson were then able to take the short side of the deal by buying insurance on the bonds referenced in the deal.
In turn, the long investors were the insurers. They received regular payments, much in the same way insurance providers do, from policyholders like Paulson. These payments were much like the interest they would accumulate had they actually owned the bonds outright. In exchange, they agreed to make large payouts to the short investors should the bonds fail, which is exactly what happened.
During the downturn, Goldman was hardly the only firm that allowed investors to employ these naked credit default swaps. In fact, naked shorts are viewed by many as one of the prime reasons why the housing collapse was so painful. "The naked CDS... wreaked havoc on the market," says Greenberger."
Note to class: do not be surprised if I ask you to explain the risk profile of a Credit Default Swaps or CDOs on the final. If this undergrad from Harvard did it, so too should you!