Default Credit Swaps in the Subprime Market

I’m about 80 pages into my latest reading, ‘The Big Short’. The book takes you through the lives and situations of different characters as it tells the story of the big short that took place during the housing meltdown of the last few years in the states. It’s almost like a novel.

In part of the story we learn how a very intelligent guys foresees all the mortgages that are going to go bust and tries to figure out how to profit somehow by betting against the mortgages.

Briefly, as you may know, lenders gave out mortgages to many unqualified borrowers from their homes. They then sold these mortgages to other financial entities as interest producing bonds. For some bizarre reason many big firms bought these bounds to make money. One of the weirdest things about the whole situations is that the rating agencies (Firms that give a rating as to how safe investments are) was giving triple A ratings on these bonds.

In investing, using financial leverage (borrowing) can make someone enormously rich in a short amount of time if they make the right bets. Of course, the flip side is that you can dig yourself a huge hole if you are wrong.

The main character in our story eventually found a way to bet against these mortgage bonds to make a killing. He bought something that was created around that time called a ‘credit default swap’, which is like an insurance policy on a bond. So he would pay a monthly premium to a financial entity to insure his bonds. As longs as the bonds held up, he would keep paying and the other side would keep earning monthly payments, but if the bond failed he would get a big insurance payout on each failure.

Our character was a smart guy. He picked all the worst mortgage bonds he could find. He actually read all he could about who the money was lent to, in what conditions – 100% financing, no down payment, teaser rates, this was all great if it formed part of the mortgages that the bonds were created from.

I guess the book is called ‘the big short’ because he, and later others, started ‘shorting the subprime market’. It’s amazing how fast people can get rich if they understand money and can foresee certain events or shifts.

Here is the official definition via Wikipedia of a credit default swap:  Contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default.