Have you ever wondered about credit default
swaps? Didn't think, so, but we’re gonna talk about 'em anyway. This little demonstration
illustrates the CONCEPT of asset-backed credit default swaps, but it’s not exact, I’m
taking a little creative license here to make the point. So here goes. A person buys a house
-- I know this is a barn, but again — creative license. So the homeowner gets a mortgage
from the bank and uses it to buy the house. The homeowner pays the bank dutifully every
month — a little principal, a little interest. A little principal, a little interest. Now,
the bank might start to get a little antsy, because this homeowner’s credit might not
be so great, she might lose her job, she might stop paying on the loan at some point and the bank wants to make
sure they get their money. So here’s where an insurance company or other large financial
institution might step in and say, “Hey there, Bank, how 'bout if we sell you this Credit
Default Swap? If Susie Homeowner defaults on her mortgage, we’ll guarantee to pay
it off ourselves.” Well that sounds great to the bank, so they make the deal — and
now when the homeowner makes her mortgage payment each month, the bank gives a little
bit of the interest to the insurance company in payment for the credit default
swap's guarantee. The bank’s profit is a little bit lower, but that’s okay because their
risk is lower too. So: what could possibly go wrong here? Well,
what if there were trillions of dollars in credit default swap arrangements covering
all kinds of bonds and other debt? And what if just a few giant financial firms were on
the hook for all that money? And what if they didn't have enough capital set aside to cover themselves
if the economy fell apart? And then — what if the economy fell apart? Of course that’s
exactly what happened in 2008. And of course the American taxpayer stepped in with trillions
in cash to keep those giant financial firms afloat. And what about our intrepid homeowner?
Millions of them did lose their jobs, got foreclosed on, lost their homes, and got accused of being irresponsible
for buying a big house and taking out a big loan. This is a problem that still has not
been fixed. And on that cheerful note,
