What is a mortgage default swap?

Answer 1

I believe you are asking about credit default swap. Say I have a bank, and I have a certain risk or exposure of losing money on bad home loans, I may look for someone I can pay, to guarantee the repayment. I'm the buyer of "credit protection" and the seller now has assume the risk of the bad loans. Now, the insurance analogy is quite clear. It may appear that since I bought credit protection, the loans I hold are worth more. This works so long as the seller of the swap has the cash to make good in case of non-payment (default). The swap seller has to consider the percent of loans he might have to pay out on. He sets the swap price for the "credit protection" accordingly. But, here's the rub- he may have a lot of statistics on the percent of bad loans, and the number will be very low, say 0.5%, but that's in the housing boom times. In good times, home owners without the income to pay simply re-finance with the added equity in their homes. They tap into their credit cards for quick cash. Obviously, in bad times, the swap seller runs short of money to guarantee the loans. The buyer of the swap is now in the hole too. His credit rating drops as the swaps no longer offer same protection. There is also the concept from statistics that if there are many loans involved, then the risk should be more accurately factored into the price, as averages tend toward the population mean as the sample size increases. Unfortunately, the population mean (strictly just a concept) in this situation is not stationary (fixed in time). As one economist put it, you can't make a bad loan into a good loan with insurance or swaps. The swap moved the credit risk exposure from one institution to another. In good times, it was win-win for buyer and seller. In bad times, we have lose-lose. While the swaps have similarity to insurance, it's not like fire or theft insurance as all the fraction of houses on fire or being broken into does not suddenly rise. This is referred to as systemic risk in the credit default swaps. See more: http://www.investopedia.com/terms/c/creditdefaultswap.asp Also, Wikipedia has a good description of credit default swaps. It's a complicated area and I would appreciate anyone with experience in this area who can add to this. Some extra points to add on to this: 1. With CDS the banks expected the risk of loan defaults to be transferred to the Insurance Provider. When a default would occur they would go to the Insurance provider and get the loan default amount

2. The Insurance provider did not expect a whole group of population to surrender their homes and close their mortgage loans. When the default rate on the loans in the bank increases, the collateral or the security amount the Insurer has to place as amount for credit protection increases. When the defaults increased many fold the swap providers were unable to increase the credit protection amount. This is why AIG went broke and the US government had to pitch in to help it...