Home Foreclosures Credit Default Swaps and Interest Rate Swaps
Swaps as defenses to home foreclosure
Everyone has heard the expression “To Big To Fail”–in fact there was a movie made by HBO films with the same title. For me, these credit default swaps and interest rate swaps can be defenses to home foreclosure because the large banks that constructed these derivative-based, collateralized debt obligations (CDO’s), collateralized mortgage obligations (CMO’s), mortgage-backed securities (MBS’s), asset-backed securities (ABS’s), special purpose entities (SPE’s), structured investment vehicle (SIV’s) real estate market investment conduits (REMIC’s), etc., then initiated home foreclosures probably purchased a credit default swap, an interest rate swap, a total return swap, or some other type of “insurance”.
A QUICK WORD ON DERIVATIVES
The best way to explain a derivative is to start with what it is not. A stock, bond, or a mutual fund that is usually made up of stocks and bond is the common stuff and are investments. People are familiar with these “securities” because they are advertised, widely owned, and because people have them in their IRA or in the 401(k). These investments or securities are the back-bone of investing and are not derivatives. An ounce of gold, a bushel of corn or a home are also investments, but they cannot be called securities like the stocks, bonds, and mutual funds. Derivatives are the things that you buy or sell that are based on the value of stocks, bonds, gold, corn, or real estate. When you don’t want to own a security, or more generally, an investment, but you want to make money by speculating on its future value (up or down) you are a speculator. When you own an investment or security, but want to minimize your losses in case your investment does not turn on as planned, you are a hedger. Derivatives are generally much riskier (large change in price), more volatile (quick change in price), and more difficult to understand than more traditional investments. This is why everyone was so stunned by decreasing home values. Normally, real estate is the least risky of all the above. Derivatives (swaps) based on the housing market changed everything and for a very long time, they were completely unregulated–even after Enron.
Swaps as “insurance”
For foreclosure defense, many large banks and investors were compensated when your home went underwater so maybe the plaintiff in your foreclosure lawsuit did not lose as much money as they say they did–maybe. These institutions could have had swaps in place to minimize their losses, or perhaps there was a “real” insurance policy like mortgage insurance to pay the lender in case you were not able to make payments. The Federal Housing Administration (FHA) under HUD is the largest insurer of home loans.
swaps are not true insurance
In order to have true insurance, the insurer has to have an insurable interest in what or who is being insured. For example, to have an insurable (vested) interest, you can purchase life insurance on a family member or a business partner, but you cannot purchase life insurance on someone you don’t have any meaningful relation to. Why? Insurers cannot afford to pay life insurance benefits to U.S. Commandos if they wanted to insure the life of Osama Bin Laden before attacking him. Also, insurance companies are regulated by state laws, and just like banks, are required to have minimum capital requirements or cash reserves to pay out. The more cash deposits or policies a bank or insurance company has, the more cash reserves it needs in case people start defaulting on their loans for cars, homes, credit cards, school loans, businesses–or in the case of insurance companies–just in case several insured people die (life insurance), or there are several car wrecks with injuries (auto insurance), several home fires, hurricanes, land slides, thefts (property and casualty insurance), or insolvent governments that cannot pay the interest on debt they issued like Greece or Jefferson County, Alabama, etc. The great recession and the government bailouts reminded us that if banks do not have money, then no one has money.
Swaps are private contracts or agreements
These “swaps” are private contracts or agreements between large institutional investors, like banks, mutual funds, hedge funds, government bodies (small governments like Jefferson County, Alabama or entire nations like Greece, called “sovereigns” ). If you think swap sounds like a “swap meet” or a place where people go and trade things with each other–your right! In a swap, one entity is swapping its rights for another’s rights because it thinks it is getting a better deal. Most often, both entities are getting a better deal . . . at least at the time.
Swaps are used to minimize risk or to speculate
Sovereign swaps, home foreclosure credit default swaps and interest rate swaps can be structured in many different ways but they all basically have two purposes: either to minimize risk or to speculate. As you may have guessed or know by now, too much money was used to speculate. If a large enough amount of money is used to speculate, the stock market, housing market, bond market, futures market–even a horse race can be tilted in the wrong direction. For example, if you are at the horse track and everyone starts betting on one particular horse, the odds or the perceived risk that the horse will lose decreases. I say perceived risk because even though the #4 horse in the 3rd race is going off at 3 to 1 odds (looks like a winner) 5 minutes before post-time, does not mean that the #4 horse is going to win. . . it just means everyone is betting on the #4 horse because they think it will win, or they think it will win because everyone else thinks it will win. The #9 horse going off at 50 to 1 odds could be the winner.
Know that in the public financial markets like the New York Stock exchange or the more private markets (“over-the-counter”) money can be made by and increase in value as well as a decrease in value by people who are “bearish” (term more often used with traditional investments like stocks and bonds) or are going “short” or are “short” (term more often used for derivatives) because they believe an investment is going to go down in value. It sounds weird that a person can bet something is going to go down in value or “lose”, and it can get complicated, but just think of it like this: if you bet money that the Miami Heat are going to beat the Boston Celtics, then you are bullish or going long on the Heat and you are bearish or going short on the Celtics.
Everyone intuitively understands this and if you have ever made a bet that your team is going to win Saturday’s game with someone, you are in fact, a speculator, not an investor. An investor would buy stock shares in their favorite team or become a lender by purchasing a bond and loaning money to their favorite team (btw, maybe they exist, but I have not seen bonds on teams, just corporations and governments).
A complex, but easy to understand example
counter-parties, the swap buyer, the swap seller, and the reference entity.
If you can believe that, maybe you can believe this. Now, just imagine that you (a counter-party), instead of betting $20 bucks with your buddy that Heat (the reference entity) are going to win, imagine you can place a bet for $20 dollars that the Celtics are going to lose. This is the way the financial markets work: maybe I don’t want to buy company stock in the Celtics hoping it goes up in value, maybe I want to sell short–not quite the same as short-selling a home–(sell now at a high price and buy back later at a low price).
Now, imagine that you as a Heat fan can bet that the Celtics will lose by 10 points or more or you can bet that the Heat will win by 10 points or more, or both, if you want. Now imagine that you still want to bet on the Heat, but you think the Heat will barely pull it off. The problem is that you only “win” if the Celtics lose by 10 points or more, or in the more usual case when betting, if the Heat wins by 10 points or more. This is because the Heat are favored by 10 points–this is the “spread”, sound familiar? As a loyal Heat fan who loves his team, you still don’t want to see your favorite team lose and lose $20 so you the counter-party and “swap-buyer” find another ”counter-party” and “swap seller”–who will “insure” your bet for some of the difference if the Celtics lose by 10 points or less (or the Heat win by 10 points or less) and who will pay you $10 so that you only lose $10 instead of the whole $20 bet you made. You may even find someone who will reimburse you the whole $20 dollars instead of just $10. If you do find a guy that will pay you the full $20, he is an even bigger speculator and sounds like AIG.
Now imagine there is another guy out there who thinks that the Celtics will lose by 10 points or more (or the Heat will by 10 points or more) and so he is willing to take money now to “reinsure” the guy who insured you. This is because the guy who insured you thinks the Heat will win by 10 or more (or the Celtics will lose by 10 or more) but is still afraid he will have to pay you $10. This is how swaps continue to grow and compound one another, but we are not done.
Hang in there. There may be a Celtic fan out there who wants to bet on his home team just like you want to bet on your home team, but he realizes that he can only make money if the Celtics win. However, he sees an opportunity to make money even if the Celtics lose, which would certainly make him feel a little better if his Celtics did lose. In order to make some money and feel better if his Celtics lose, he decides to be a “swap seller” himself. So this Celtic fan enters into a swap from the guy that insured you. You just paid money to this counter-party to insure you in case your favorite team–the Heat–loses. This same counter-party, the one who insured you, and the one who bought reinsurance figures he is pretty well covered, so he would now like to bet “against” the Heat by using the money you paid him by paying the Celtic fan as a swap-buyer in case the heat loses by 10 points or less.
The three main parties here are the Celtics fan, you the heat fan, and the middle-man. The other party was just a reinsurer to show that insurance companies buy insurance.
Now. the Celtic fan is afraid that his speculation will cost him. Remember he wanted to make money just in case his team lost. Remember the 10 points spread is locked in and you the Heat fan would normally not get paid unless you ”beat” the 10 point spread, but the Celtics fans get paid if they win by one points or 25 points. So the Celtic fan does something similar to what you did when you hedged your bet: the Celtic fan finds or tries to find someone who will cover his bet (remember he made money as a “swap-seller” to the guy who insured you), and reduce his losses if the Heat win by 10 points or more or even win by 10 or less (if that swaps is available and depending on much faith the Celtic fan has in his team) .
So the Celtic fan does find someone who informs him that there are people just betting on the 10 points spread and not on who actually wins–true speculators who are running “naked swaps”–naked because they don’t care who wins, they are not season-ticket holders and don’t own stock shares in the teams. These are the Lakers fans and they don’t care if the Heat or the Celtics win, they just want to make money, so they bet a LOT of money that the Heat will win by 10 points or less and can accept and will cover the Celtic’s fan new bet that the Celtics will lose by 10 points or more (or that the Heat will win by 10 points or more).
As you can see, these swaps grow enormously and are compounded and multiplied. Any party to a swap agreement can find a counter-party to hedge their bet or to speculate. If they start regretting their bet, they can find someone who will cover that bet or they can buy reinsurance and that reinsurer may buy reinsurance or go out and enter into swap agreements to hedge or speculate himself. These “bets” or swaps are priced and just like any other security or derivative, they go up in value and down in value depending on how the market changes.
Home Foreclosures Credit Default Swaps and Interest Rate Swaps