Hi Fang,
OK I get it up to this point .....
I have heard about this on the news and this is the bit where my brain circuit breaker trips. Could you explain this bit in idiot level english 
I can take a crack at it... BUT, I honestly am not 100% clear on how it was all done myself and I have not only read a good bit about it but a friend whom I used to work with in the mortgage business and who went on to deal with collateralizations and SIV's explained how they did theirs but some of it still makes no sense to me. I suspect that a situation may have developed where nobody really know what they were doing but everyone was making lots of money so nobody cared.
Ok.... So a lender puts together a set of mortgage loan underwriting guidelines. That includes credit requirements, program parameters (term, amortization...), collateral requirements, loan to value and debt to income ratios and a whole mess of other areas to evaluate for approval. Underwriting guidelines often run 100+ pages or more for a given loan program.
The lender then has these guidelines reviewed by a ratings agency like Standard and Poors or Moody's and the loan pool that is to be made up of the mortgage underwritten to the guidelines is given a rating, hopefully AAA or AA.
Now the lender takes the loan program to market and begins closing and funding mortgages. This may be through direct retail channels but more often it is through offering the products to the huge network of independent mortgage brokers across the nation. The lender will then fund the closed loans through a warehouse line of credit, basically a short term lending credit line used to fund mortgage short term until they can be packaged up into a large pool of loans and sold off. Depending on the size of the lender, they may pool up a bunch of loans (usually less than $500 million) and sell off the entire pool in once package to a much larger lender. Many of the largest lenders actually do nothing buy buy up smaller pools and then package them into much larger pools and securitize them.
Once a pool of loans that is very large is acquired.... the lender will confirm the ratings agency rating and then structure up securities or bonds to sell that will be backed by the mortgages. These are Mortgage Backed Securities (MBS). This market is fairly simple and determining the assets value is also simple.
But Derivatives.... thats a mess. Here is what Wiki says...
A credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.[1] This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.[2] Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.[3]
The parties will select which credit events apply to a transaction and these usually consist of one or more of the following:
* bankruptcy (the risk that the reference entity will become bankrupt)
* failure to pay (the risk that the reference entity will default on one of its obligations such as a bond or loan)
* obligation default (the risk that the reference entity will default on any of its obligations)
* obligation acceleration (the risk that an obligation of the reference entity will be accelerated e.g. a bond will be declared immediately due and payable following a default)
* repudiation/moratorium (the risk that the reference entity or a government will declare a moratorium over the reference entity's obligations)
* restructuring (the risk that obligations of the reference entity will be restructured).
Where credit protection is bought and sold between bilateral counterparties this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic CDOs; credit linked notes; single tranche CDOs, to name a few. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.
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So... investment bankers who were selling off the MBS's decided that these relatively simple investment vehicles needed more goodies to be associated with them. Goodies to supposedly help mitigate or spread around the risk. These default swap derivatives could be bought supposedly as a means of spreading risk from a position in just one pool of MBS to MANY such pools. So the simplest way to think of these derivatives is to think of them like insurance in the sense that the derivative itself has value as a security and can be traded and the yield and value from the derivative is meant to offset potential loss from the MBS itself.
The problem is that delinquencies and defaults on MBS's have exceeded by a large margin ratings agency projections and this has caused the value of the supposedly hedging against such risk derivatives to become impossible to determine. The mortgages backing the MBS's are not servicing as they were supposed too and the values of the derivatives were based on the MBS's projected servicing expectations. This is not on just a few pools of MBS's..... but LOTS (all???). This is made much worse by the fact that these MBS's are not publicly traded and those holding them do not release data on how they are performing and in fact do not want to do so because if they did it would push the MBS's value much lower and potentially make the holder insolvent (mark to market anyone?).
The way the risks on these MBS's SHOULD have been managed was with insurance. But insurance does not pay like derivatives do and who wants to be an insurance salesman when you can be a Hedge Fund manager?
I hope that helps. If you do not really understand it, you have lots of good company as I am not really sure ANYONE does and that is itself a huge part of the problem. One of the reasons an RTC type of solution to this is difficult is the crazy complicated nature of this debt paper.
Fang
