I wish someone would explain how this works.
I don't understand it entirely myself (I'm not alone in this regard), but what I've figured out so far is that:
- The first key step is that the banks and mortgage brokers selling mortgages at the retail level, to you and me, no longer keep these long term loans on their books, but rather package up a bunch of them as a Mortgage Backed Security (MBS) and sell them, shortly after the mortgage is created. They take their money and run. This means that the people selling mortgages these days no longer have long term skin in the game, so are encouraged to sell mortgages that aren't healthy.
- The second step (and the above first step) is nicely explained in the YouTube video to which I linked in my Post #128 above. Low quality MBS's are sliced and diced to create high quality AAA rated paper, in a bit of financial alchemy that is now coming unglued. Along with this, the two major rating agencies MBIA and AMBAC, who provided these AAA ratings are themselves failing and have lost their own AAA rating, which once realized will drive down the AAA ratings of all this toxic paper, drastically lowing their value.
- The next step(s) I am less clear on. It seems to involve writing derivative contracts (not traded in any open market) called Credit Default Swaps (CDS) in which hedge funds "insure" the banks and investment firms against losses on these assets ... however hedge funds aren't regulated and well backed institutions operating with a high degree of public transparency.
Try a
Google search for "credit default swap mbs cds" for more explanations of this. One link I see on that search looks useful and more readable:
Intro to Credit Default Swaps.
The first key step ... The second step ...
Yeah, those steps are clear.
The next step(s) I am less clear on. It seems to involve writing derivative contracts (not traded in any open market) called Credit Default Swaps (CDS)
These are different than equity or debt securities. If you buy a stock or bond, they can become worthless.
If you buy a CDS to protect your bond purchase, you're not typically going to buy 10 times the insurance on your bond. And even if you did, that won't turn $10 trillion in losses into $100 trillion in losses.
Say a CDS on your $1 billion in MBS costs $10 million a year to insure (just picking a number out of the air, feel free to use your own). Every one of your mortgages defaults in the first year. You're protected because your CDS issuer will pay you $1 billion. Except the CDS issuer took your $10 million payment and then went bankrupt. You lose $1.01 billion, not $10 billion or $100 billion or $100 trillion.
These fear mongers take something that everyone understands, leverage, and try to use it in an area where it doesn't really apply.
It makes good copy. $100 trillion!! Bigger than US GDP!! How can we ever pay it back? But if they ever explained it correctly, it wouldn't really apply.