Last week, Scott Lewis SLOP’d about the San Diego County pension system’s sizable investment in D.E. Shaw, a hedge fund that is heavily involved in so-called “credit default swaps.”

If you’re like most people, you probably started to lose consciousness by the end of that last sentence. But stay awake if you can. Because it turns out that San Diego’s fortunes are very much tied to these arcane financial instruments

Credit default swaps, or CDSs, are basically a form of insurance that lenders of money purchase in order to ensure that they will be paid back. That, at least, is the idea. Let’s examine a hypothetical, certainly oversimplified, but hopefully illustrative day in the life of a CDS.

To get the whole ball rolling, a would-be homebuyer in San Diego decides he wants one of those fancy stated-income, stated asset, low-down-payment, negative-amortization loans the doom-mongers are always going on about. Thus can he afford, temporarily at least, much more home than a stodgy fixed-rate mortgage would allow. Our homebuyer hopes that by the time the mortgage recasts and his payments spike, his wealth or income will have grown to the extent that he can actually make the payments. A mortgage lender is only too happy to oblige.

This doesn’t sound like such a great deal for the mortgage lender, the likes of which have traditionally demanded a collateral – proof that they will be repaid – more substantial than “hope.” But not to worry! The mortgage lender doesn’t typically remain as such. More often than not, mortgage lenders package up loads of mortgages into bond-like “mortgage-backed securities” and sell them to yield-hungry investors.

To review the money flow so far, the mortgage company initially lent various homebuyers a chunk of change in return for the promise of future payments. But in step two, the buyer of the mortgage-backed security (MBS) repaid the mortgage lender’s money and so became the rightful recipient of the future mortgage payments.

You’ll notice that at this point, the mortgage company is actually out of the picture and no longer has to concern itself with the matter of the loan actually being paid back. Perhaps this helps explain some of the loans these companies are writing.

But while removed from the mortgage-lending process and accordingly shielded from some of the more questionable practices therein, even the buyers of the MBS may feel some vague unease at the prospect that some of the homebuyers might not be able to make good on their mortgage payments.

At this point, yet another player enters the game. Let’s call this player the “insurer.” The MBS holder pays the insurer ongoing premiums, just as you pay the auto insurance company ongoing premiums, in exchange for default protection. In other words, if a certain number of homebuyers default on their payments to the MBS holder, the insurer will make up the difference. And thus is the credit default swap created.

At this point, everyone is happy. The homebuyer got his loan; the mortgage company its fees. The MBS holder gets its income stream and the warm feeling that it is protected against the chance that the homebuyer can’t make his mortgage payments. The insurer gets its premiums. And while I used mortgage-backed securities as an example, this virtuous circle can take place among many types of debts which may be sliced and diced into a variety of increasingly complex financial instruments.

So what’s the problem? While the above transaction seems innocent enough, there are some concerns about the effects of CDSs on the financial system as a whole. At this point, several trillion dollars worth of credit is insured through CDSs, a number that has grown by leaps and bounds in just a few years. The CDSs are themselves often bundled up into complex financial instruments that are traded back and forth to the extent that it’s not even always clear – to the insurees, financial regulators, monetary authorities, or anyone else – who’s on the hook should a borrower go into default, let alone whether that party could actually come up with the money in a pinch.

That last point is really the big issue: CDS issuers are not typically insurance companies in the traditional sense, but rather financial institutions or our old friends the hedge funds. And it’s simply not clear that the insurers have enough capital to actually pay off the policies they’ve written. I don’t think anyone in the world has that information, and I’m certain that I don’t.

But I do know that hedge funds employ mathematical models to determine things like default risk, which in turn tells them how much cash to keep on hand in case they need to make good on the insurance. I also know that these mathematical models sometimes fail spectacularly if their assumptions are not met.

Unlike an insurance company, which is typically intended to be a viable long-term business, hedge funds’ fee structures encourage many funds to make big, risky bets. At the same time, recent years in the mortgage market have been pretty much default-free, a trend many observers – and mathematical modelers, I’ll bet – thought would continue forever. Considering this idealized data set alongside many hedge funds’ naturally risk-seeking behavior, it certainly seems plausible that some credit insurers do not have enough cash reserves to cover the amount of defaults we will likely see in the years ahead.

Long story short (is that possible at this point?), we may see some blowups among CDS issuers. This would almost certainly have the effect of raising the cost of CDSs – the premiums – as insurers realized that CDS writing was not the license to print money that they once thought.

From the MBS buyers’ perspective, problems in the CDS market could lead not only to increased insurance premiums but also to doubts about whether the lenders were actually insured by a solvent party. The net effect being that they might not be so quick to snap up those “non-traditional” mortgages that everyone loves so much.

For high-flying housing markets like San Diego, that would be bad news.

– RICH TOSCANO

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