A Daring Trade Has Wall Street Seething – WSJ.com

Extraordinary. Long-ish story short is:

Some big banks pay 90% of this face value for credit-default-swaps (insurance) on a mortgage-backed-security they think is going to default (but they don’t own). Their counterparty (insurer) pays off the loans in the MBS and doesn’t have to pay the swap. Pockets the premiums (which were big) minus the cost of paying off the loans.

The real-life analogue to this? Your house is on fire. Your neighbors all buy fire insurance on your house from a friendly agent, promising to pay if the house on your lot is destroyed. The agent walks over to the burning hulk of your house, puts out the fire, repairs the damage, and tells your neighbors “the house isn’t destroyed” so he doesn’t have to pay out. The cost of fixing the house is less than the premiums your neighbors paid.

Before going and buying this sure thing, wouldn’t you ask yourself why in the world anyone would write insurance on a burning house/sure-t0-default MBS? Or what incentives there were if the agent wrote insurance for more than the house was worth?

via A Daring Trade Has Wall Street Seething – WSJ.com.

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