Credit Default Swaps: The Insane Problem and the Radical but Sane Solution

[Joanne98]

The paramount reason for today's cancerous credit crisis is seldom even hinted and never explained.

First, a simple definition. A credit default swap is a form of insurance. A variant of mortgage insurance required of many home purchasers. An insurance policy that requires a company with financial strength to step up to the plate and pay the mortgage if for some reason the home buyer defaults.


A credit default swap is similar: If default occurs, an insurance company pays the income stream of the mortgage.

With one extremely important difference: Payments are made to the owner of the policy, not to the financial institution that stands to suffer a loss.

Financial institutions are allowed, through total lack of regulation, to buy and sell credit default swaps, or insurance they will be paid in event of default, on financial instruments in which they have no financial interest.

Start with a simple example. Assume I know the young son of the couple next door likes to crawl into closets and play with matches. I therefore see a reasonably good shot at "winning the disaster lottery" so to speak, by buying fire insurance on their $200,000 house.

In simple terms, I now have a financial interest is seeing that disaster occurs. If the house, for whatever mysterious reason, burns down an insurance company will pay me the insured value of the house - even though I suffered no loss, financial or otherwise. My neighbor's misfortune is thus magically transformed into my good fortune. A polite way of saying I was paid $200,000, the insured value of my next-door neighbor's house, after I paid the $400 insurance premium.

Being bright and suitably equipped with an MBA from a prestigious eastern university, I well and fully understand the desirable objective of maximizing my return on investment. I can accomplish this in one or both of two ways - increasing the return or decreasing the investment.

I can increase the return by artificially increasing the value of the house - say from $200,000 to $400,000. This will allow me to collect twice as much for suffering no personal loss. The easiest way to accomplish this would be to hire one of my buddies, who happens to be a real estate appraiser, to "document" the higher value.

I could also decrease my investment - meaning the premium I paid for the insurance, say from $400 to $200. The easiest way to do this would be to hire a widely acclaimed "fire risk rating agency" to send out an inspector who will look around (or perhaps only drive by without stopping) and then solemnly declare: "This house is fireproof".

Either of the two most prominent and widely known fire rating companies would be excellent choices, based on their prior experience.

In the real world, meaning Main Street as opposed to Wall Street, this would be illegal. Against the public interest, because it encourages houses to mysteriously burn down. The insurance policies owned by people without a financial stake in the fire would be declared null and void because they are contrary to public policy, which sees minimizing the number of mysterious house fires as a good thing.

Rather than a bad thing, as now occurs under America's predatory capitalist system.

Now change an assumption. Assume I tell 99 of my poker-playing gambler friends about the boy's strange and dangerous interest. Starting with my appraiser buddy, who's predatory income as a result of a mysterious fire will double, as a direct result of his appraisal.

Now assume the $400,000 house burns to the ground. One hundred or so insurance companies will collectively pay $40 million in claims on the loss of a single $400,000 house. The benefits of a $400,000 disaster are magically multiplied by a factor of 100 and transformed into a $40 million disaster - with one family suffering a loss and 100 families experiencing a gain. The losses of the insurance companies don't count, because, in America's capitalist society, they are in the business of writing insurance - and paying claims for losses.

But in today's society, fire is not the only disaster that can be insured against. Of particular interest, default on a home mortgage can be insured against. And possession of an interest in the mortgage or actual risk of financial loss as a result of default is not required in order to purchase the insurance.

Continued>>

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http://www.opednews.com/articles/CREDIT-DEFAULT-SWAPS--THE-by-Chuck-Simpson-080924-49.html

[sandnsea]

1. WaMu Depositor Money will cover Morgan Stanley liquidity n/t

[Joanne98]

3. And the FDIC will cover the depositors money. Pretty slick huh.

[John Caelan]

9. They aren't losing money, they are forced to reveal they never had it to being with...

In a nutshell, the problem of the swap market comes down to this:

"There is not enough money in the world to circumvent a massive correction in the market. Literally. That's the problem. There is not a lot of money, actual wealth, at all. There are just a lot of people saying they have money. They hold up a bond that's worth six cents and declare, "This is worth a dollar." You think it is a damnable offense that some family lies on a mortgage application, exaggerating assets, to get a loan? Corporations like Lehman, Fannie and Freddie, AIG, and the whole line up yet to come all did this to the tune of hundreds of billions. But with every default, more of these toxic bonds get found out. You see, the corporations aren't really losing money; they are just being forced to reveal that they didn't have the money in the first place. This is why "the credit" has come to a standstill. That is the usual consequence of lying to your creditors..."

http://blog.myspace.com/index.cfm?fuseaction=blog.ListAll&friendID=17986969

[mike_c]

2. and we're supposed to pay the greedy f*cks' bills...?

Recommended. Excellent explanation. Everyone who participated in this ponzi scheme should lose everything. Instead, we have to pay their "losses" to keep the credit engines turning. Can't anyone see how insane this cycle is?

[ContinentalOp]

4. That's a great article! I'm only on page two but I have a question.

About the 99 friends analogy, is that really true? Multiple people are allowed to buy insurance on one mortgage backed security even if they aren't the people holding the loan? And if the borrower defaults, the total insurance amount is paid to each of these multiple people?

[htuttle]

8. It's true

It's just like a person can have multiple life insurance policies on them, with different beneficiaries.

And I think that third parties can buy life insurance on other people with themselves as a beneficiary. A few years ago, it was reported that Walmart was taking out life insurance on their older employees (ie., the greeters) and putting themselves down as the payees. That's still legal, as far as I know.

[Wilber_Stool]

5. Great article.

You need to x-post this in GD. Nobody will see it here. I'll wait a while and do it myself if you don't.

[NoUsername]

6. Thanks for posting that!

I've read a couple of things on credit default swaps but never quite understood exactly what they were. The article you posted explains it clear as day.

Now that I know what they are, holy shit! It's absolutely insane that there can be more than one insurance policy on, say, a house, or that disinterested parties can buy them. Damn. And people wonder why Wall Street is in the shape it's in.

[OakCliffDem]

7. kick

[truedelphi]

10. I was wondering about the term "credit default swap."

Do you think it would be immoral if we grab Paulson, drape him in a moose hide, and set him loose behind the Palin back forty, way up there in Alaska?

Right after we have all taken out some hefty life insurrance on him??