What keeps me stumped on these CDSs (credit Default swaps) was how you could have say $2 trillion in mortgages loans, but have $50 trillion worth of CDSs underlying these loans. WTF?
How is a $700 billion Rescue package going to help?
I am really trying to get a handle on what is going on now, so here goes. Feel free to dive in anytime and beat the hell out of my ignorance. I would appreciate it. I have to start somewhere.
- I buy a $10 million dollar "slice of mortgage bundles" packaged up by Fannie Mae, etc.
Good investment, good returns compared to anything else available...say they get 6 % payback at the time of loan payback (Interest gets paid first before principal). World-Wide cash needs to go somewhere...this market is so big it could handle HUGE amounts of incoming investments...one of the only markets this big...no limit.
- Prudence requires that I buy some kind of guarantee or insurance that this investment will not go south and I lose my ass. Since buying these "slices" does not allow me to examine the underlying loans for their quality, it becomes imperative that I buy "insurance" to spread out the risk and cover my ass in cause of default.
- ok, here is where the rubber meets the road. I can to go the OTC Credit Default Swap market for this "investment insurance" (over the counter...means NO regular Exchange to monitor stuff like insider knowledge--aka Martha Stewart, cooked books--aka Enron,etc). No enforcement...wild west...whatever you can get away with...anything goes.
This is a totally unregulated market, anyone can go on their computer and enter a site that looks like a bulletin board and post up an offer to SELL a credit swap. I will pay someone to take on on some of this risk offsetting my exposure to loss on the "slice" I bought....I offer to pay 2% of the loan value if the buyer will accept any losses for 2 years (No one is going to "buy" a credit swap for 30 years. And since once a borrower is in a home for three years, he has a very small statistical probability of default, I just need to cover my ass for this 3 year stretch. Notice that the credit swap duration is for two years...you are going to have to roll over this swap again to get through the three year actuarial period that gives a predictable outcome to the loan.
Now, the risk paper that you sell on the swap market is NOT MADE DIRECTLY ON THE PACKAGED "SLICE".
You sell a bet that the housing market and the general economy (lets say we use a common standard of general economic well-being like the Dow Jones 500 daily average) will not change radically while I hold the paper.
- Here is how a swap is offered to cover this mortgage slice I bought:
I offer on the swaps OTC market to SELL a swap. Remember that I am trying to cover the risk i assumed when I bought a $10 million slice. On the last day of the two year period, a calculation will be made on who owes whom some cash...not the 2% that you give the swap buyer at the start. That is just the initial cost of the swap contract on day one paid to the buyer by the seller (you).
You bet with the swap buyer that you will owe him one dollar for every point that the Dow has gone down at the end of the two years. And since you are covering a $10 million investment, you are saying that you will pay the swap buyer $10 million for every point that the Dow goes down. SAY WHAT? I just bet against myself and my investment of $10 mil.
Its called offsetting your risk. Bookies do it all the time. If a Super Bowl comes along that pits my beloved 49ers against the Patriots, and a bookies gets 90% of his bettors putting money on the Niners, he sees he could lose his ass if the Niners win (forget point spreads for now). The bookie has serious exposure, so he contacts another bookie, and makes a corresponding bet that the Niners will win...amount equals say a little less than all the bets he is covering for the Niners to win.
Result...If the Niners win he has help covering his losses and paying off the winners through his bet with the other bookie. If the Patriots win, he collects more money from his bettors than he has to pay the other bookie.
CYA.
Likewise, if I make an investment in these "mortgage slices" in good times, I will gain a tidy return over the life of the investment...if times are still good in the future.
However, I need some protection if economic times go bad. Ergo I offer to sell a $9 million swap on the OTC market that will pay me $9 million/point that the Dow has fallen in two years compared to the Dow today. I bet against the successful completion of my own initial investment in mortgage slices. I may lose out big time in buying these mortgage slices if the economy takes a dump, but my covering bet that the market will go down will pay me $9 million /point of downward Dow movement.
CYA.
Its that $ "per point" rise and fall that is the real sticker. Its an open-ended financial obligation.
If there is a 500 point Dow rise (good economic times), I have made a good investment in mortgage slices. But my covering bet that the Dow is going down is going to cause me to owe the swap buyer (who took my bet on the drop in the market) 500 points X $9 million = $45,000,000.
The $700 billion Rescue only covers the cost of the initial swap contract off of the original Swap seller. The government will now own the contract...AND THE POSSIBILITY OF HUGE LIABILITIES THAT THE US GOVERNMENT WILL HAVE TO PAY OFF.
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ok, now that i can put down my crayon, how far off is my knowledge?
thanks, gunslinger