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

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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.

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The author is a retired professional civil and structural engineer, reformed attorney, fierce Progressive, policy junkie, vociferous reader, lifelong learner, aspiring writer and author of the crime-thriller "The Geronimo Manifesto". He is also a (more...)
 
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Excellent, simple terms, explanation of crisis and... by Kent Welton on Thursday, Sep 25, 2008 at 12:39:58 PM
all of the others who looked the other way while r... by Mark Adams on Saturday, Sep 27, 2008 at 3:40:11 PM
is to boycott the election and to refuse to vote i... by Mark E. Smith on Thursday, Sep 25, 2008 at 4:01:30 PM
Mark, I certainly share your frustrations and sens... by Chuck Simpson on Thursday, Sep 25, 2008 at 4:16:43 PM
Chuck wrote:Mark, I certainly share your frustrati... by Mark E. Smith on Thursday, Sep 25, 2008 at 7:35:59 PM
Mark, I have and continue to do a great deal of re... by Chuck Simpson on Thursday, Sep 25, 2008 at 9:01:52 PM
The current administration has stolen everything t... by Matthew Peters on Thursday, Sep 25, 2008 at 10:09:19 PM
Well done.  Logical.  Makes sense. ... by pft on Thursday, Sep 25, 2008 at 6:42:50 PM
advocating closure of bank accounts for a year now... by jeff prager on Thursday, Sep 25, 2008 at 8:04:20 PM
Thanks for a truly easy-to-understand article on c... by Jean Braun on Thursday, Sep 25, 2008 at 11:13:19 PM
it was the corrupt and partisan Supreme Court that... by Mark E. Smith on Friday, Sep 26, 2008 at 3:10:46 AM
  A must watch film: Empire of the ... by Mr M on Friday, Sep 26, 2008 at 7:28:14 AM
It helps me understand why the Republicans have be... by Bernard on Friday, Sep 26, 2008 at 8:51:17 AM
Many years ago, after consuming several alcoholic ... by Chuck Simpson on Friday, Sep 26, 2008 at 9:14:31 AM
A comment received via E-mail:Chuck--I appreciate ... by Chuck Simpson on Friday, Sep 26, 2008 at 12:10:54 PM
"We made it possible for banks to get their credit... by kei kei on Tuesday, Sep 30, 2008 at 10:01:23 PM