Question about Credit Default Swaps and their relationship to Mortgages:

[coalition_unwilling]

Folks, I believe I have a pretty good understanding of the financial meltdown that has been occurring recently.

I do have a question that some of you with experience in financial services industry may be able to answer:

What is the relationship between a mortgage, a car loan, or a credit card balance and a Credit Default Swap (if any)?

Here is a hypothetical example (purposely kept simple) of my question:

Let's say I'm a banker at Bank of America and I decide to issue an ARM mortgage for $500,000 to a borrower whose credit is less than sterling. I am thinking that the borrower's wages cannot pay the mortgage over its lifetime (and especially after a 3-year re-set to a higher rate). But I am betting that continued appreciation in the price of housing will allow said borrower to re-finance to a fixed rate mortgage.

However, I am not 100% sure of my thinking, so I wish to acquire a Credit Default Swap that will insure against the borrower defaulting on his mortgage.

Four questions:

1) Does the BofA mortgage banker go to the market to purchase a Credit Default Swap from a CDS provider like AIG?

2) If yes, what is BofA purchasing, insurance that BofA will be made whole in case the mortgage defaults?

3) If, in my hypothetical example, AIG sells BofA a Credit Default Swap, is\was AIG required to maintain any capital reserves against the possibility that the loan would default?

4) BofA sought insurance against a default, AIG (and its like) sought revenue by insuring against a default. Both parties probably assumed housing prices would continue to rise, hence very little risk. Was the risk all along that the rate of increase in housing prices (the "housing bubble") could not keep indefinitely outpacing increase in median income\wages?

I'm just trying to make sure I have a good, general understanding of the rot.

Edited to add: I would be especially interested in the insights of HamdenRice or NadinBrezhinski (or their followers) on these questions.

Further edited for clarity of expression.

[HamdenRice]

1. A few points

First of all, a bank would not buy a cds for a specific consumer loan. It might buy it for a security that was backed by many thousands of consumer loans, like a mortgage backed security or a credit card receivable backed security.

Here's a basic explanation of a cds from another thread:

A credit default swap is an insurance policy that a bondholder buys. Paraphrasing the colorful names used in the Wiki article, let's say that Penion Fund wants to buy bonds from Risky Corp. It buys $10 million in Risky Corp's bonds which are 7% bonds for 5 years.

Risky Corp pays 7% interest or $700,000 each year. If Pension Fund gets scared that Risky Corp will default, Pension Fund can go to AIG and ask to buy a credit default swap.

Let's say the credit default swap costs 300 basis points (that's a fancy way of saying 3%). So Pension Fund pays AID $300,000 per year out of the $700,000 per year it gets from Risky Corp.

That may sound like a lot but it means (or was supposed to mean) that there was no chance that Penion Fund could lose money. If Risky Corp sends out a letter saying, we've run out of money we're not paying interest and may not be able to pay you your $10 million in year five, under the credit default swap, Pension Fund can go to AIG and say, here's Risky Corp's bond, we want our $10 million back and AIG has to give it to them -- even if Risky Corp's bonds are now selling for $2 million on the open market because of the default.

The worst thing about credit default swaps is that the repugs put a clause in the bankruptcy code that says that credit default swaps are basically exempt from waiting in line during bankruptcy if the issuer (AIG) of the credit default swap goes into bankruptcy.

That means that while AIG's bondholders, suppliers, employees, contractors -- everyone who was owed money -- would have had to wait in line if AIG had been allowed to go bankrupt, while the bankruptcy court tried to figure out how to pay off AIG's debts, holders of credit default swaps, like Pension Fund could just go and demand payment and get it.

Credit default swaps were purchased on trillions of dollars worth of mortgage backed securities, which means that the default of mbs means that certain issuers, like Lehman, are on the lines for billions and billions -- supposedly to be paid before bankruptcy even starts.

3) If, in my hypothetical example, AIG sells BofA a Credit Default Swap, is\was AIG required to maintain any capital reserves against the possibility that the loan would default?

No. Thank Phil Gramm for that. They were considered commodities (like derivatives) but were even exempt from commodity regulation. They were exempt from insurance regulation as well, so there were inadequate reserves.

4) BofA sought insurance against a default, AIG (and its like) sought revenue by insuring against a default. Both parties probably assumed housing prices would continue to rise, hence very little risk. Was the risk all along that the rate of increase in housing prices (the "housing bubble") could not keep indefinitely outpacing increase in median wages?

Yes.

[coalition_unwilling]

2. Thanks so much for that. So, if I'm reading you correctly, it's the

bond holder (perhaps an entity that had purchased a tranche of mortgage-backed securities) who would have need of a credit default swap and not the mortgage issuer. (I made mortgage issuer BofA my entity that needed the CDS merely to anchor the argument in something physical.)

I cannot believe that reserve requirements were not made a part of this scheme. I thought insurance companies were required to maintain reserves against losses. If I understand correctly, Warreen Buffett made his initial fortune by selling insurance and using the 'float' on insurance premiums not needed for reserves to invest in other businesses. But Buffett was always required to maintain reserves against possible losses, I think.

Just starting to immmerse myself in the nuts-and-bolts of this stuff and even doing so makes my head spin, so I appreciate your patience with me.

[DCKit]

3. The whole thing sounds like a complete set-up.

As if they intended to fail and have the Fed bail them out.

Normally I'd say "They're just not that smart" but this looks like a well-thought plan.

[coalition_unwilling]

4. I'm unwilling as yet to exclude the

possibility of LIHOP\MIHOP.

But have you seen any evidence to support the idea?

So far, I have read a lot of speculation, some more convincing, some less so. But the only evidence I have seen is at best circumstantial (like having had a version of the bailout plan for a few months), and none thus far to suggest "malice aforethought" (as exists with Iraq-nam) or conspiracy to defraud.