Today’s word is “credit default swap.” Basically we’re well past the point where mere mortgage fraud and default is the problem. Over the past decade, lenders made it possible for people to take on home loans they never should have gotten into, either because the borrowers were too poor to buy a house at all, or because the excessively generous initial terms (low initial rates, “liar loans,” etc.) tempted people to buy homes that were too expensive, or to buy too many homes.
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Let’s say, for example, that I take out a mortgage. All that means is that the bank gives me a bunch of money, and I have to pay it back with interest. I’ve made a legally-binding promise, and that promise is worth money. So the bank will try to loan as much money as it can, since it stands to make money from each promise.
Normally a bank would strike this balance by making loans on safe terms. But by limiting risk in that manner, they limit their potential market.
When I can’t pay my mortgages, the bank goes to the CDS issuer and says, hey, he defaulted, so you have to pay out from the insurance we bought. The issuer takes the money that it made from the CDS premiums or other investments and gives it to the bank. But then a second bank wants its money. And a third, and so forth. That’s what happened to AIG: “In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world. . . .”
And when those promises can’t be fulfilled, we don’t know what they’re worth. They exist, but no one has any idea if those promises have any value, and if so, how much.
Paul Krugman argues that Paulson would have to buy those troubled assets at far more than “fair price” because otherwise the bailout would mean fuck-all. And for kindly bailing their ass out we, the tax payers, would have no ownership over the companies: “Mr. Paulson insists that he wants a ‘clean’ plan. ‘Clean,’ in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out.”
