All analogies break down when pushed far enough. I know this. But bear with me.
Say my name is Goldman, and you are Sachs (or vice-versa). We recently bought a house for $165,000 cash. The fair market value is $200,000. Our friend, Lehman, wants to buy it, but he's making $400/month payments to his brother for a car loan that he got on a handshake deal, and he can't make a 20% down payment. We tell him we'll take 5% down, and we'll finance the balance with interest payments he can afford. We require a financial statement from him which leaves out the part about the car loan. We close the deal.
Then we take all the mortgage papers and Lehman's financial statement to another friend, Mr. AIGner, who is an insurance agent/bookie who thinks he knows something about real estate finance. We tell AIGner (with tongue in cheek) that although we know we have made a very solid loan, we'd like for him to sell us a kind of insurance policy against Lehman's possible default. AIGner examines the documents,and goes for it. We agree to pay premiums of $100/month for a $200,000 "policy'.
Then we put the word out that we have a golden mortgage loan for sale. Lots of people who trust us want to buy it. The more we talk it up, the greater the demand to buy it increases. We decide to sell the loan at auction. The bidding is frenzied, and our other friend, Stearns, pays us $210,000 for the note. We transfer it to him. We no longer on the hook as a lender.
But we still own the "insurance policy".
So when Lehman defaults two months later, we have $419,800 in bank (which we also own), and everyone else is screwed and tattooed.
This is how credit default swaps work. This is how Goldman Sachs hyped crummy mortgage paper (that they knew was crummy), sold it to people who should have known better, and put AIG on the hook for all of it.
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