Credit Default Swaps — Now I Get It

I *thought* I understood what credit default swaps (CDS) were all about and the role they played in the collapse of our financial markets. But thanks to a terrific interview by Terry Gross, it’s finally really clicked me. On a recent edition of Fresh Air, Frank Partnoy did a great job of explaining it.

I knew that CDSs are essentially bets placed on so-called securitized mortgages. Specifically, a CDS is like a short sale. It’s a bet that a mortgage or (more accurately) a portion of a bundle of mortgages will default and not be paid back.   The underwriter of the CDS (an AIG for example) is essentially betting against you and has to pay you if the loans are not repaid. It’s obviously a lot more complex than that, since why would you buy something from a company that only made money when your investment turned out not to be a good one. (Why? It’s like placing a bet with a bookie. There’s supposed to be another gambler on the other side. If not, the bookie has to make good, paying for his risk out of the difference in the spreads.)

But here’s the important new insight I learned from Partnoy. These really are bets and the reason they’ve brought down our econoy is that there’s no limit to the number of bets that can be placed on a single underlying mortgage or traunch. As a simplistic example, for a $300,000 mortgage AIG can sell as many bets as it wants. Since the bets aren’t backed by the mortgage itself, let alone the collateral (the real estate), there could be tens of millions of dollars riding on that single mortgage. It’s not just the kind of leverage we’re used to in which you borrow money in order to make ore investments. No, these aren’t “investments* — they’re *bets*. And just like in Las Vegas, the amount that can be bet on something isn’t limited by the value of that thing. IOW, all of these bailouts are in order to cover the losses of bookies and to make sure that those who gambled get their payoffs.

Partnoy also explains how it came to be that Bill Clinton signed the deregulation that got us into this mess in December of 2000. It’s fascinating in a sick and twisted way. I actually look forward to learning more as more books are published over the coming years.

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