Credit Default Swaps Defined and Explained

Editor’s Comments: Everyone now has heard of credit default swaps but very few people understand what they mean and fewer still understand their importance in connection with the securitization of residential mortgage loans and other types of loans.The importance of understanding the operation of a CDS contract in the context of foreclosure defense cannot be understated.

In summary, a CDS is insurance even though it is defined as not being insurance by Federal Law. In fact, Federal Law allows these instruments to be traded as unregulated securities and treats them as though they were not securities.

Anyone can buy a CDS. In the securitization of loans, anybody can “bet” against a derivative security ( like mortgage backed bonds) by purchasing a CDS. FURTHER THEY CAN PURCHASE MULTIPLE BETS (CDS) AGAINST THE SAME SECURITY. In the mortgage meltdown, Goldman and other insiders created the mortgage backed bonds to fail — collecting a commission and profit in the process — and using the proceeds of sales of mortgage backed securities to purchase CDS contracts for themselves. So they were betting against the value of the security they had just sold to investors. The investors (pension funds, sovereign wealth funds etc.) of course knew nothing of this practice until long after they had purchased the bonds.

The bonds were represented to be “backed” by mortgage loans that collectively received a Triple AAA rating from the rating agencies who were obviously in acting in concert with the investment bankers who issued and sold the bonds. There were also other contracts that were purchased using the proceeds of the sale of the bonds that performed the same function — i.e., when the bonds were downgraded or failed, there was a payoff to the lucky investment banker who issued them or the lucky “trader” or bought the insurance or CDS. Sometimes the proceeds were used to pacify the investors and sometimes they were not.

The significance of this in foreclosure defense, is that while the investors were getting bonds for their investment, the bonds incorporated the mortgage loans, which is another way of saying that the investors were funding the loans through a series of steps starting with their purchase of mortgage backed bonds. Thus it was the investor who was the ONLY creditor in the transaction that funded a homeowner’s loan (at least initially before bailouts and payoffs of insurance and proceeds of CDS contracts).

The other item of significance is that the securities did not need to actually fail for the CDS to pay off. That is precisely why AIG got into an argument with Goldman Sachs that eventually led to the bailout. All that was needed was for the issuer or some other “trustworthy” source to downgrade the value of the bonds or announce that a substantial number of the loans in the pool were in danger of default, and that was enough to claim payment on the CDS contract.

The translation of that is that even if your loan was paid up or only slightly behind, someone was getting paid on a CDS contract in which a series of mortgage backed bonds were marked down in value. This payment was received by the investment banker who was the central figure in the securitization chain. And, as stated above, sometimes these proceeds were shared with investors and sometimes they were not — which is why identification of the creditor and getting a complete accounting is so important.

But the issue goes deeper than that. The investment banker was acting as the agent or conduit for both the actual creditor “investor) who was lending the money and the debtor (borrower or homeowner) who was borrowing the money. Therefore the payment of proceeds in a CDS may have accomplished one or more of the following:

  1. Cure of any default by the debtor as far as the creditor was concerned, since the investor or its agent received the money.
  2. Satisfaction through payment of all or part of the borrower’s obligation.
  3. Obfuscation of the real accounting for the money that exchanged hands
  4. Payment of an excess amount above the amount owed by the debtor which might be a liability to the debtor under TILA, a liability to the investor, or both, plus treble damages, rescission rights, and attorneys fees.
  5. Opening the door for non-creditors to step into the shoes of the actual creditor who has been paid, and claim that the debtor’s non-payment created a default even though the creditor or his agents is holding money paid on the obligation that either cures the default, satisfies the obligation in full, creates excess proceeds which under the note and applicable law should be returned to the debtor.
  6. Creates an opportunity for some party to get a “free house.” In the current environment nearly all of the houses obtained without investment or funding of one dime is going to these intermediaries whom I have dubbed pretender lenders. Note that the financial services industry has taken control of the narrative and framed it such that homeowners are claiming a free home when they borrowed money fair and square. But at least homeowners have put SOME money into the deal through payments, down payments, or lending their credit to these dubious transactions. The free house, as things now stand is going to parties who never invested a penny in the funding of the home and who stand to lose nothing if denied the right to foreclose.

FROM WIKIPEDIA —–The article below comes from www.wikipedia.com

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) undergoes a defined ‘Credit Event‘, often described as a default (fails to pay). However the contract typically construes a Credit Event as being not only ‘Failure to Pay’ but also can be triggered by the ‘Reference Credit’ undergoing restructuring, bankruptcy, or even (much less common) by having its credit rating downgraded.

CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:

  • The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.[1][2][3][4] In contrast, to purchase insurance, the insured is generally expected to have an insurable interest such as owning a debt obligation;
  • the seller need not be a regulated entity;
  • the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;
  • insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets;
  • in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;
  • Hedge accounting may not be available under US Generally Accepted Accounting Principles (GAAP) unless the requirements of FAS 133 are met. In practice this rarely happens.

However the most important difference between CDS and Insurance is simply that an insurance contract provides an indemnity against the losses actually suffered by the policy holder, whereas the CDS provides an equal payout to all holders, calculated using an agreed, market-wide method.

There are also important differences in the approaches used to pricing. The cost of insurance is based on actuarial analysis. CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with other credit market instruments such as loans and bonds from the same ‘Reference Entity’ to which the CDS contract refers.

Insurance contracts require the disclosure of all risks involved. CDSs have no such requirement, and, as we have seen in the recent past, many of the risks are unknown or unknowable. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claims. In that respect, a CDS is insurance that insures nothing.

One Response

  1. Great info and explanation!

    Now does anyone actually hold a CDS contract they have received in discovery?

    It would be helpful to gain access to this info for use prior to discovery but it seems no one can view the Top Secret info that ruined our lives.

    If anyone has a copy of a CDS or derivative contract I would love to see one. Anyone?

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