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How Are Losses on Mortgage Derivatives Calculated?

Toy houses; woodleywonderworks via Flickr

Question: If there is no way to currently value the mortgages on which the value of derivatives (collateralized mortgage obligations, etc.) depend, how are losses on those derivatives — such as AIG $62 billion loss — calculated? If you can’t value something, how do you write it down?!

Paul Solman: AIG is heavy into credit default swaps (CDSs). For an in-depth explanation of what a CDS is, you can see our recent piece on the topic. (And for Jon Stewart’s humorous mockery of our explanatory methods, watch the first minute or so of THIS piece.)

Credit default swaps are traded openly, their price changing minute by minute. Once the prices of AIG’s swaps dip below a certain value, the company may be required to put up more collateral – in effect, to add to the pool of money set aside in an escrow account, say. That’s money the government would now have to put up.

Same thing for mortgage-backed securities. Deals have been made, sales consummated. There’s a tussle over which prices to use as benchmarks, but almost any price might trigger a similar collateral bump, which the government would have to cover.

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