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I still don't understand it. I need someone to start with: Joe Poor wants to buy a house, but doesn't have any money or job. His bank lends him the money anyway. It seems to me that the guy who stamped "APPROVED" on his loan application just co-signed for Joe's loan.

Someone take it from here and explain the rest to me. I couldn't follow Ben's explanation.

I’ll try.

Joe Poor gets the mortgage, which the bank resells to someone else (probably Fannie Mae or Freddie Mac). They then bundle it with a bunch of other mortgages, divide it into bonds and sell it off again.

Someone buys the bonds. They get nervous about getting paid back and find someone else who will insure the bond for a premium, just like you pay for car or home insurance. That bond insurance is the credit default swap (CDS).

Confusing, but so far, there’s no real problem.

Now it can get ugly. Other financial firms can build more CDS contracts around that same bond even though none of the parties to those contracts actually own the bond. This part of it is more like a bookie taking bets, think of the two sides of the CDS contract as a bet on a ball game, except team A is the bond defaults and team B is it gets paid on time. There’s no limit to how many of these CDS bets can be created and there’s no organized, regulated market for them.

Now, go back to Joe Poor. He defaults on his mortgage and a few other folks in the same mortgage bundle fall behind. Those payments no longer support the cash flow that goes with the bonds our friends Fannie and Freddie made back in step two or three of this story. The bond goes into default or partial default, triggering payment on the CDS. But remember, the only limit on the amount CDS riding on that bond was how many investors wanted to place bets. So Joe’s $200k mortgage default might have triggered $3 or 4 million of bets.

Repeat thousands of times. I believe the total CDS market is something like $62 trillion - with a T. The CDS market includes corporate bonds, municipals, basically any type of debt instrument out there.

You may have seen the news coverage on the Securities and Exchange Commission halting short stock sales. The news release that isn’t getting so much coverage is that they’ve also launched an investigation into suspected market manipulation involving CDS on corporate debt among other things.

Hopefull some smart Freepers will chime in to correct any mistakes I made.

I still don't understand it. I need someone to start with: Joe Poor wants to buy a house, but doesn't have any money or job. His bank lends him the money anyway. It seems to me that the guy who stamped "APPROVED" on his loan application just co-signed for Joe's loan. Someone take it from here and explain the rest to me.

Well, you did not follow the process until the end.

After making that loan to Joe Poor, the banker then took Joe Poor's IOU and sold it to the manager of your mutual fund that expected a nice, steady yearly return on the investment of YOUR mutual fund money.

So, you not only countersigned the loan ...... you BOUGHT it.

The guy who approved the loan is now enjoying the commission he got from selling that IOU to your mutual fund. It's not his problem anymore.