Who can explain credit derivatives in layman's terms?

[Bern80]

This is the part of this whole I don't quite understand yet and how the market for them seemingly caused all this? Can someone explain it laymans terms?

I understand about about Joe Blow obtaines a mortgage from company ABC, then ABC did.....what exactley w/ that mortgage?

 

[NOBama]

From investopedia.com:

Credit Derivative

Privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments).

For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.

 

[gonegolfin]

This is the part of this whole I don't quite understand yet and how the market for them seemingly caused all this? Can someone explain it laymans terms?

I understand about about Joe Blow obtaines a mortgage from company ABC, then ABC did.....what exactley w/ that mortgage?

Credit derivatives are simply financial instruments that are intended to be used as hedges against debt positions. But they are also used to simply trade for profit (Ex. many credit default swaps can be issued against the same underlying debt instrument). Credit Default Swaps are a perfect example. Here, a credit default swap bought long is a short position against some debt instrument (such as a set of corporate bonds). That is, it is insurance against the default for that debt. But if you have an entity holding a long position in a credit default swap, you also need someone to take the short position. The entity taking the short position is known as the writer of the credit default swap. For example, AIG has a huge book of credit default swaps that they wrote against a variety of debt. They collected handsome premiums for writing those contracts. But both the debt default rates and the decline in price of these instruments has been such that they have had to writeoff a lot of losses on these investments (both due to default as well as simply marking their investments to market).

What you describe above with mortgages is not related to credit derivatives. You are talking about mortgage securitization (either privately via investment banks or publicly via Fannie/Freddie). Of course, credit default swaps can be written against mortgage backed securities (both residential and commercial).

Brian

 

[Richard-H]

As Society evolves so does greed. There is no end to the inventions that greedy people will come up with to find new ways of stealing money from the people that actually create the wealth.

These derivatives are just such an invention, the only thing unique about them is that they became so far out of touch with the realities of economics that they completely backfired.

Reality has a way of doing that.

 

[Paulie]

As Society evolves so does greed. There is no end to the inventions that greedy people will come up with to find new ways of stealing money from the people that actually create the wealth.

These derivatives are just such an invention, the only thing unique about them is that they became so far out of touch with the realities of economics that they completely backfired.

Reality has a way of doing that.

This is a ridiculous statement. There is nothing inherently wrong with derivatives. If not for all the bad debt KNOWINGLY taken on by these banks, and the people who borrowed, the derivatives market would not be in the situation it is in.

 

[Bern80]

Okay udnerstand what they are. Lending company X give a mortgage to someone. They now have Y amount money owed to them. So some company (A) offers to buy that debt. So what then? It would seem then that X now has the money it was owed be the lendee, so obviously now (A) is owed some money, right? And who is the lendee really paying now?