Why mortgages are killing the economy...

I've been wondering why mortgages have been such a contributor to our market weariness...  and I think I finally figured it out.

We've had regional and even larger foreclosure crises before... plenty of market drops and the like... but why do we suddenly have to buy mortgage houses now?

Insurance... or the lack thereof.

From my basic research... banks long ago determined that they could take bigger risks if their loan investments were covered by insurance.  They created a marketplace to buy and sell this insurance, and they guaranteed payouts in the event of a loss.  That financial insurance instrument is called a credit-default swap.

But a credit-default swap(CDS) is NOT insurance, it is only an instrument.  It's not regulated, nor is it required to be backed with liquid assets of any real amount.

On the books though - a CDS looks pretty good.  And if you want too... you can even trade them like stock called derivatives.  They were one-way bets on banks that mortgages would fail (thus they were seen as stable and creditworthy because mortgages shouldn't EVER fail... right)  - so banks started selling LOTS of them.

To the tune of 62 Trillion dollars in derivatives market value.   Yes Houston - nearly 9x the US national debt of 9.3 Trillion.

Now's about the time it all clicked for me.  See - suddenly any bad debt could be papered over with CDS.  Never mind that CDS was nothing other than a pie-crust promise that mortgages would always pay.  Never mind that banks then further fueled the insanity by trading them like real money.

If you had potentially toxic loans - it would be covered with a CDS...  You were effectively spreading the risk of failure to all the schlubs you bought a CDS from.

Aha... so that's why Goldman Sachs and Morgan Stanley "suddenly" want to be real commercial banks.  They must to bring in real cash to cover their CDS obligations or risk an AIG death dance.

Because there really is no protection when it's not regulated.  AIG was loosing billions on CDS contracts back in February... they had written over 500 Billion in CDS contracts and were still growing.  Papering over bad debt became a drug habit response in the investment industry and now the real cost was suddenly rising rapidly to the point where insuring 10 million could cost 2.5 million up front!

And so when real foreclosure numbers started ramping up over the past two quarters... well lets just say it was going to be a slaughter.