Credit Default Swaps: The Insane Problem and the Radical but Sane Solution

With nearly 4 solid years of foreclosure injustice spewing from the courts and millions of homeowners continuously getting skunked, it has become a necessity to figure some way to explain to even the brightest (judge) on the bench the answer to, “[D]id you pay?” 

It doesn’t matter what state (although some are a lot worse than others) or what faction of the judiciary, state, federal, bankruptcy, appellate – the question they always ask, “[D]id you pay?”  We’ve all heard the standard answers:

  • “I don’t know who to pay…”
  • “I owe someone, but it’s not these guys…”
  • “I lost my job, but I can pay now and they won’t take my money…”
  • “All I need is a little reduction in my monthly payment…”

The list goes on – but the real answer if there is a trust involved might be, “Well, your honor, I don’t think I’m in default.” And of course the judge is going to say, “why is that – did you pay?” And the likely response might be, “your honor, there’s these things called Credit Default Swaps and my note is current and my investor is paid…”  And so it goes…

While taking some time to research Credit Default Swaps (CDS), this long but too good to be true article popped out making CDS into an elementary explanation that even a layperson could understand – voila!

About 3 years ago, Chuck Simpson (no relation to Homer or OJ) wrote this amazing piece – a head of his time. Simpson describes himself as “a retired professional civil and structural engineer, reformed attorney, fierce Progressive, policy junkie, vociferous reader, lifelong learner, aspiring writer and author of the crime-thriller “The Geronimo Manifesto”.  He is also a law-abiding but avid proponent of progressing America back to its earlier ideals of freedom, fairness, justice and opportunity for all.”

It’s a long read – but you’ll be thankful you took the time. This is where brilliance begins.

Credit Default Swaps: The Insane Problem
By Chuck Simpson
(September 25, 2008)

The paramount reason for today’s cancerous credit crisis is seldom even hinted and never explained.  First, a simple definition. A credit default swap is a form of insurance. A variant of mortgage insurance required of many home purchasers. An insurance policy that requires a company with financial strength to step up to the plate and pay the mortgage if for some reason the home buyer defaults.

A credit default swap is similar: If default occurs, an insurance company pays the income stream of the mortgage.  With one extremely important difference: Payments are made to the owner of the policy, not to the financial institution that stands to suffer a loss.

Financial institutions are allowed, through total lack of regulation, to buy and sell credit default swaps, or insurance they will be paid in event of default, on financial instruments in which they have no financial interest.

Start with a simple example.  Assume I know the young son of the couple next door likes to crawl into closets and play with matches. I therefore see a reasonably good shot at “winning the disaster lottery” so to speak, by buying fire insurance on their $200,000 house.

In simple terms, I now have a financial interest is seeing that disaster occurs. If the house, for whatever mysterious reason, burns down an insurance company will pay me the insured value of the house – even though I suffered no loss, financial or otherwise. My neighbor’s misfortune is thus magically transformed into my good fortune. A polite way of saying I was paid $200,000, the insured value of my next-door neighbor’s house, after I paid the $400 insurance premium.

Being bright and suitably equipped with an MBA from a prestigious eastern university, I well and fully understand the desirable objective of maximizing my return on investment. I can accomplish this in one or both of two ways – increasing the return or decreasing the investment.

I can increase the return by artificially increasing the value of the house – say from $200,000 to $400,000. This will allow me to collect twice as much for suffering no personal loss. The easiest way to accomplish this would be to hire one of my buddies, who happens to be a real estate appraiser, to “document” the higher value.

I could also decrease my investment – meaning the premium I paid for the insurance, say from $400 to $200. The easiest way to do this would be to hire a widely acclaimed “fire risk rating agency” to send out an inspector who will look around (or perhaps only drive by without stopping) and then solemnly declare: “This house is fireproof”.

Either of the two most prominent and widely known fire rating companies would be excellent choices, based on their prior experience.

In the real world, meaning Main Street as opposed to Wall Street, this would be illegal. Against the public interest, because it encourages houses to mysteriously burn down. The insurance policies owned by people without a financial stake in the fire would be declared null and void because they are contrary to public policy, which sees minimizing the number of mysterious house fires as a good thing.

Rather than a bad thing, as now occurs under America’s predatory capitalist system.
Now change an assumption. Assume I tell 99 of my poker-playing gambler friends about the boy’s strange and dangerous interest. Starting with my appraiser buddy, who’s predatory income as a result of a mysterious fire will double, as a direct result of his appraisal.

Now assume the $400,000 house burns to the ground. One hundred or so insurance companies will collectively pay $40 million in claims on the loss of a single $400,000 house. The benefits of a $400,000 disaster are magically multiplied by a factor of 100 and transformed into a $40 million disaster – with one family suffering a loss and 100 families experiencing a gain. The losses of the insurance companies don’t count, because, in America’s capitalist society, they are in the business of writing insurance – and paying claims for losses.

But in today’s society, fire is not the only disaster that can be insured against. Of particular interest, default on a home mortgage can be insured against. And possession of an interest in the mortgage or actual risk of financial loss as a result of default is not required in order to purchase the insurance.  In this case also, I can increase my return with an inflated appraisal and decrease my investment by declaring the risk to be minuscule – meaning rated AAA by widely acclaimed rating agencies.

We can now change another assumption. Assume the playing with matches problem is removed and a new problem is substituted. A problem like the husband and wife both having low-paying jobs and no health insurance, coupled with knowledge that many employers refuse to accept illness as a legitimate reason for missing work and have iron-clad policies that require ill workers be fired for failing to report to work.

Or assume both husband and wife have no seniority and work at jobs that may not exist tomorrow because they were shipped overseas last night. If I knew one or both of them were developing health problems or that one or both were at risk of being laid off, I would see a reasonably good shot at “winning the disaster lottery” so to speak, by buying mortgage default insurance, also known as a credit default swap, on their $400,000 house.

Then I could sit back, relax and wait for the hoped-for and expected misfortune, which will be my good fortune. As could 99 of my gambling buddies.

Back to the neighbor’s home that mysteriously burned to the ground. This tragic event is a great deal for me and my 99 gambling buddies. Our biggest risk is that, having paid the insurance premiums, the home stubbornly refuses to burn to the ground.

Being capitalists, we desire to increase the odds that a disastrous fire will occur. My friends and I with fire insurance policies on my neighbor’s house have two options for increasing the odds. One, teach the young child the joys and wonders of paying with matches in closets. Two, hire a professional arsonist.

Holders of credit default swaps have similar but more numerous and less risky opportunities to increase their odds of “winning the disaster lottery”.

The best way would be use of fine-print, non-understandable escalator clauses that increase the hard-working couple’s monthly payments by a factor of two or three. With rampant inflation, confined to core goods that officially “don’t count” in Washington, such as $4.00 gasoline, $5.00 milk and $3.00 bread. With rampant if covert support of immigrant labor, legal or otherwise, who are willing to work for less, without any benefits at all, let alone health insurance, thereby increasing the risk of job loss.

We could destroy OSHA, making on-the-job causes of illness and injury more likely. We could buy legislation that benefits pharmaceutical companies while making both medicine and health insurance unaffordable. We could destroy the economy of Main Street, making job loss more likely. The list is extensive, collectively making early default all but inevitable.
That issue addressed, our biggest worry becomes the solvency of the insurance companies. That problem can best be solved by requiring substitution of a “bigger and better” insurance company with deeper pockets.

Purchasing legislation and regulations (or the lack thereof) is the preferred method.
Roughly a quarter-century ago, when I was owner of a new and small consulting engineering firm in a Midwestern state, a law was passed requiring that operators of coal strip mines reclaim the messes they made. To ensure this might actually happen, the new law required coal mine operators to post reclamation performance bonds, payable to the state. So if the operators went bankrupt, the state could call the bonds, thereby obtaining funds for the state to hire and pay remediation contractors.

I never understood at the time why the small independent strip mine operators had so little interest in hiring a consulting engineer to design mining and reclamation operations so as to minimize reclamation expense, or even to provide honest estimates of expected reclamation expenses. Until, in an unguarded moment, one small operator explained Plan B.

At the time, only $250,000 in financial assets were required for formation of an insurance company, and once formed, no limits were placed on the value of insurance written. Same for performance bonds written to the government that granted the license and regulated.

As chance would have it, a dozen or so small mine operators joined together and kicked in about $20,000 each, thereby building a kitty of $250,000. They solicited a straw man and formed their very own little insurance company. That company specialized in writing strip mine reclamation bonds, with the state as an insured party. The amounts of the bonds were based on remediation cost estimates that were provided by the operators who paid for the bonds. This insurance company was issued a license even though the owners never at any time had any intention whatsoever of paying claims they knew would be filed.

Mining operations continued as before. Meaning horrendous messes were left behind. When the meses were discovered, ABC mining companies declared bankruptcy. Corporate assets, usually consisting only of a worn-out backhoe and a dilapidated dump truck, were liquidated for each of the companies. DEF mining companies with different well-used backhoes and dump trucks were formed to exploit the next sites.

As to ABC’s sites: The state called upon the insurance company’s performance bonds so the state could clean up the messes. And the state did.

Reclamation work “estimated” by the mine operators to cost about $6 million was performed, at a cost of about $70 million. All but about $250,000 was paid for by the taxpayers, after the insurance company filed bankruptcy.

Substituting A.I.G. and similar institutions for the name of the miner’s small insurance company will explain much of America’s current situation.

As with reclamation of strip mines, the insurance companies will file for bankruptcy. Government, via a $700 billion emergency rescue plan, will step up to the plate. The costs will be paid by taxpayers who have seen only losses and no gains. Pursuant to a rescue plan that prohibits any and all forms of congressional or judicial oversight or opportunity to object

Except for reports, to be filed twice yearly. Something akin to the fox being required to periodically report how many chickens he stole from the hen house, without being required to return any of the stolen chickens. And who will keep this count? The fox.

The inevitable bankruptcy of A.I.G? What other option exists for a company with a market value of $12 billion and liabilities of about $450 billion on credit default swaps written to hedge funds, many of which are headquartered offshore and thus pay no taxes in the United States. For this, the government is paying $85 billion in taxpayer’s money. In return, the government, meaning the taxpayers, will be entitled to receive 80 percent of the company’s stock. Stock that is all but assured to be totally worthless.

For insurance company executives, financial risks of corporate bankruptcy are all but non-existent. Lehman Brothers is a prime example. On September 15, 2008 Lehman filed bankruptcy – the biggest in America’s history. Hours before, the New York headquarters was scrambling for cash. Other banks were refusing to provide loans to Lehman. Banks with loans outstanding were demanding immediate repayment. Counter parties to Lehman’s credit default swaps were selling out at ten cents on the dollar.

Lehman’s response: Hours before the bankruptcy filing, Lehman transferred $2.5 billion from the London office to the American holding company. This money had “accrued as part of group profits from the first nine months of the year” and will be used to pay employee bonuses. As a result, the London office had no funds with which to make the payroll.

Presumably. part of that money will be used to pay a bonus to Lehman CEO Richard Fuld, Jr. Last year he made $71 million. In better times, namely 2006, he was the fifth-highest paid CEO in America. His total compensation was $122.67 million.

Working American taxpayers rightly question whether firms such as this, managed by people such as this, should be bailed out. And question if the bailout will be administered fairly

Just cause exists for questioning. Should taxpayers be concerned (or outraged) that the fox who wrote the emergency plan and will be responsible for guarding government’s $700 billion hen house is Treasury Secretary Hank Paulson?

Paulson, who amassed a fortune estimated to total $700 million during his 32-year career at Goldman Sachs, the main competitor of Lehman?

    • Paulson, who will be allowed to purchase worthless securities from Goldman Sachs and offshore hedge funds at prices that he alone will determine but probably not disclose, without being subject to congressional or judicial oversight of any sort?
    • Paulson, who refused to even consider bipartisan calls for tighter regulation or reform after sending his emergency proposal to Congress at 1:30 A. M. last Saturday?
    • Paulson, whose previous employer Goldman Sachs was granted a request to convert to a bank holding company with full access to the Federal Reserve’s emergency loan program by his buddy Bernanke?
    • Paulson, who failed and sometimes refused to regulate and now claims changes to his proposal aren’t possible because of an emergency that resulted from his failure or refusal to regulate?
    • Paulson, who last Sunday rejected suggestions that his taxpayer-funded program be revised to provide any sort of relief for homeowners facing foreclosure?
    • Paulson, who steadfastly refuses to consider taking a hard look at A.I.G. and other financial firms. How could these companies, managed by the so-called “best and brightest” guys in the room, have committed such a long and horrendous series of “poor judgments”?
    • By accident, or sheer incompetence?

Hard to believe, given that everyone in the room knew millions of explosive mortgages were being written to families without sufficient income, or in some cases no documentation of any income at all, based on fraudulent appraisals and supported by fraudulent AAA ratings.

Given the size and blatant nature of the disaster, accident and incompetence excuses simply don’t fly. Something more was involved. That something is the number and size of vultures who bet on and stand to gain from the disaster, and how much they stand to gain. Too many people owning fire insurance on my neighbor’s valuable house.

In my house fire insurance example, the insurance companies that wrote the polices risk going broke, due to an unprecedented number of mysterious house fires, each resulting in an unprecedented number of claims.

The proposed bailout asks for $700 billion. The number of homes through, in the process of or facing foreclosure is currently about five million. Meaning the cost will be about $140,000 per home.

But the problem as to credit default swaps is much bigger. The notional value of credit default swaps outstanding is estimated to be about $62 trillion.

This is about $12.4 million per home. About 31 times the value of a $400,000 home.
No wonder America is experiencing an emergency of mysterious financial house fires. And who will benefit? Those who taught and then encouraged the boy to play with matches.

The Sane Solution

Our leaders warn of dire consequences: If the $700 billion bailout bill is not passed immediately, without debate, let alone modification, economic growth will “suffer”.
But America has already experienced years of economic growth. And suffering. The parasitic, predatory type of growth I’ve described has already resulted in many years of much suffering on Main Street.

More suffering? The honest, hardworking people of Main Street USA who would never dream of attempting to make a profit on someone else’s disaster deserve to see much more than suffering. They deserve to see death. Of all the financial institutions that sought to get rich on the backs of hardships suffered by or intentionally inflicted on others.
This is not the type of economic growth that should be saved. This is the type of growth that should be killed in its tracks, as dead as possible, the quicker the better.

One excellent first step would be rejection of the $700 billion burden to be placed on the backs of taxpayers.

An excellent second step would be judicial declaration that the value of any and all credit default swaps is zero, as being against public policy that requires that activities than encourage mysterious fires or other forms of disaster are illegal as contrary to public policy.

Yes, you heard me right. Judicial determination that all $62 trillion worth of credit default swaps are null, void and totally worthless. Only then can a just and humane financial system can be constructed upon the ashes of the old.

This process could and should be facilitated by all honest citizens withdrawing all their funds from all financial institutions, notably including bank checking and savings accounts and money market funds, but possibly excluding local credit unions that loan in and support the local community.

I urge all American citizens to do this, as quickly as possible, to the maximum extent possible. If for no other reason, then for self-defense. All must realize no bank is safe and FDIC is one major collapse from insolvency.

The intended result: The quick death of the financial system that has sentenced all of us to a slow death.

All citizens should consider and choose: Will they be among those meekly walking to the cattle cars because of vague promises of a better life, or among those who stood up so bravely in Warsaw.

Chuck Simpson, aka azchuck
Please disseminate as widely as possible, including to all members of Congress. Preferably starting with Ron Paul.
_________________________________________________________________
By DEADLY CLEAR

See – told ya it would be good….

Whether or not you are represented by an attorney understanding the legal system is an asset.  The more you learn, the less likely you are to be taken advantage of or scammed.  Knowledge is power!

5 thoughts on “Credit Default Swaps: The Insane Problem and the Radical but Sane Solution

  1. Good, informative article, no doubt. Sad, aggrevating, infuriating. Since it was written three years ago and this very sharp mind has had a lot more time to explore the issues, I’d love to see his take now on WHO the heck owns the “securitized” note and any attendant issues. Is it that one party, the depositor, does while the investors bought the right to payments in an unprecedented play by Wall Street? What exactly happens to the sale
    proceeds of the foreclosed home?

    • I’m wondering now if that is why only term life insurance (if you could find any and afford the inflated rates) was available for mortgage death benefit coverage. IndyMac told me when I inquired about death coverage that they didn’t offer that anymore… and that “the industry stopped that a long time ago.”

    • Ditto John….I am trying to figure out who actually owns my note, who has been paid on my bankruptcy. I assume it was covered by the fdic…credit default swaps, etc. Where can I find this information. I am in the eviction process on my home of 30 years.(The debt was discharged at the time of the BK) I continued to
      pay for over 18 months, my intention was/is to keep my home.Any ideas? I am going to be in the Shire lawsuit.

  2. I don’t know who owns what nor besides discovery and actual sleuthing on the street
    how to determine and be able to prove that. But, here’s what I’m thinking after reading a white paper from the Amer Sec Forum, which imo attempts to grab art 9* and therefore contractual compliance: the acts of the banksters ultimately (if x,y,z were done) only find the trusts with “perfected security interests”. My take on the UCC – 9-203 – is that one with a perfected security interest in the note has a perfected security interest in its collateral – not to be confused with an assgt of the dot, or as more relevant to the ASF’s propaganda, that the coll instrument “follows the note”: If one has a security interest in the note, one has (only) a security interest in the coll instrument. Security interests are not ownership.
    The psa’s call for sales and assignments (pursuant to art 9, it appears). They also call for endorsements and assignments (with complete chain) of the notes and coll instruments to the trusts . I’m no authority on cds’s, that’s for sure. I can spell the words, that’s about it. But as to “standard” insurance, one must have a PRESENT interest in a thing to recover a loss. Without a present interest, one has no insurable interest or loss. (Can’t recover collision damage, say, on a car you no longer own) So, IF that’s true as to whatever insurance covered these loans, the real crime may be that the banksters willfully did not transfer the notes – as sales with possession – in order to retain their insurable interests. We’ve all just presumed acts to be done weren’t done because those bums couldn’t be bothered with the paperwork, which may have been true early in the game. But I’m thinking a bigger reason developed: insurance. The banksters get the money from the investors for the loans (which should have been sales), but then the banksters purposely don’t in fact transfer the notes, which then results (optimally) in a security interest only for the trusts. The banksters, by their design, remain the holders of the notes and claim a present, insurable interest, a most lucrative proposition because they know they’re garbage and were written with the insurance claim in mind. Nice gig and totally fraudulent. Hate that word and anyone fighting foreclosure fraud knows why, but there you have it. What makes it fraudulent is that the banksters withheld delivery and thus sale of the notes to the trusts for their own gain at the expense of the trusts’ rights and interests with mens rea. Not meeting contractual provisions is not fraud – it’s something else. Non-performance, whatever.
    But implementing a scheme which MUST avoid the contract, planning acts which will avoid the contract, and which scheme and acts benefit the schemer to the detriment of the other, as well as inducing the contract to enable a wrongful purpose and entering that contract is criminal. And on that basis, if the banksters willfully avoided sale, I’d say the investors are due a full refund of their money (with statutory interest) and damages according to proof.
    Leaving aside the criminality (!), if Party A has become indentured to Party B, and Party A is compensated for (an alleged) loss on the indentured asset, what all does that mean? If Party A is still the holder of the notes and has been or is being paid, doesn’t that mean the debt is retired or being retired by payments from the third party insurer? If Party A is the holder and is compensated for loss, its obligation, the perfected security interest, surely can’t form the basis for enforcement against the note maker by anyone, at least not before barrelling thru Party A first.
    What does that – “that” being compensation to an indentured noteholder for its loss – mean to the maker as well as the secured party as a matter of law or equity? The indenture (security interest) remains to Party B, here the trusts, and therefore the obligation. Since these notes are regulated by the UCC, as a matter of UCC law or ?, is Party A entitled to the benefit of the insurance? I think so and this provisions is probably found in the UCC. If Party B as a secured party is entitled to insurance proceeds, what does that mean to the notemaker? What does it mean to the notemaker if the party with the security interest is NOT entitled to the insurance proceeds pursuant to the UCC? (seems if nothing else, the security interest holder would be as a matter of equity, ut I’d hazard it’s addressed in the UCC) If Party A has been compensated without compensating the secured party, seems to me Party B’s first action must be against Party A. If the trusts hold only security interests, two thing seems clear to me:
    1) as non-holders, they are not entitled to enforcement, let alone under 3.
    2) foreclosure by trusts is unavailable and banksters can kiss goodbye the
    credit bids in the trusts’ names.
    @DC, not long ago, you made ref to think it was no. 8 in notes being overlooked
    despite what looks like some pretty important stuff. I agree it needs research – yesterday.

  3. *From the ASF’s (probably judicially noticeable) white paper (which I’ll be linking soon):
    “The sale of mortgage notes is also governed, in significant part, by Article 9….Article 9 addresses the sale of mortgage notes, regardless of whether they are negotiable or non-negotiable”.
    I’m not linking it yet because I’m working on picking apart the parts I see as untrue and
    propaganda, which is an ambitious project. Wouldn’t reject any help from someone I trust. Before you dismiss me or work on the white paper, keep in mind that my work so far has led me to a conclusion it’s what I said – untrue propaganda for the purpose of grabbing and relying on requisite Art 9 compliance by banksters.
    I’m not an attorney. Nothing I ever say or write is legal advice. Ask a lawyer

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