Credit Default Swaps Explained
I’ve mentioned credit default swaps before, but this article from Neil Garfield does a great job of explaining what they are and why they are important to foreclosure defense.
Credit Default Swaps Defined and Explained
>
Neil’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:
Cure of any default by the debtor as far as the creditor was
concerned, since the investor or its agent received the money.
Satisfaction through payment of all or part of the borrower’s obligation.
Obfuscation of the real accounting for the money that exchanged hands
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.
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.
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.
