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.
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