Saturday, March 28, 2009

Solution: Cancel all Credit Default Swaps

Original Link:

by Dr Squid

Having read Inky99's excellent diary, I took it upon myself to figure out just what these Credit Default Swaps are, and how does it relate to the mortgage insurance that we have to buy if we don't come up with a 20% down payment for the house we want. The conclusion I came up with: the entire Credit Default Swap market is a fraud. As such, the contracts can and should be declared null and void.

More after the jump.

Dr Squid's diary :: ::
Mortgage insurance is something that probably a rather large number of us pay for as part of our house payment, that pays off the bank in case of default. If you get a $200k house with a 5% down payment, that's about $133/month. It's a regulated insurance product that has to be cancelled by the time you own 22% of your home.

Credit Default Swaps are something related to mortgage insurance in that someone theoretically gets paid in case of default. The difference is that these are completely unregulated. Theoretically, there could be ten different contracts that pay off for the default of the same loan. As Moon of Alabama put it...

Imagine you could have ten fire insurances on your home that would each pay out the full value of your house if it burns down. That would probably give you some very hot ideas.

That is exactly the reason why fire insurance regulation prevents such a case. But CDS are unregulated, their originators are unregulated and there is no settlement mechanism for them other than the private contracts between the parties.

It's the CDS holders' demands to get paid way over what the assets are worth (The total of Mortgage and Asset Backed Securities are thought to be worth $6 trillion) that has caused all that capital to go into nothingness. It's thought that the total payout of CDS's are supposed to be about $65 trillion, or more that the GDP for the entire planet. So what to do? Make those $65 trillion in unregulated obligations go away. You bought them? Piss off. Again from Moon over Alabama...

* all financial exchanges and markets of the world close for a week
* CDS are declared null and void and new CDS creation is forbidden until new regulation is in place
* the publicly dealt financial entities have seven days to figure out and publicly restate the value of their liabilities and assets excluding all CDS
* a onetime windfall tax will be created that socializes overt advantages some entities will have from this
* the proceed of that tax shall be used to prop up the capital of the big losers in a program comparable to the Reconstruction Finance Corporation of 1932.

Is there any precedent for declaring these "contracts" void in order to save the financial system? Of course, thanks to the greatest 20th Century President Franklin Roosevelt...

During the Great Depression, many debt contracts were indexed to gold. So when the dollar convertibility into gold was suspended, the value of that debt soared, threatening the survival of many institutions. The Roosevelt Administration declared the clause invalid, de facto forcing debt forgiveness. Furthermore, the Supreme Court maintained this decision. My colleague and current Fed Governor Randall Koszner studied this episode and showed that not only stock prices, but bond prices as well, soared after the Supreme Court upheld the decision. - Luigi Zingales

It has to be done. Cancel these swaps that on paper pay more than anything that's connected to reality on this planet. Then let the old regulated mortgage insurance pay what is supposed to be paid, or let bankruptcy judges change the terms of the loan so the holders of Mortgage Backed Securities can get a little bit more than they would get in case of foreclosure.

You don't get what you say you were promised when you bought a contract that says to pay $2 million in case of a $200,000 default? Tough tuchus. Buyer beware applies to you too.

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