Something has always bugged me about credit default swaps and mortgage/bond insurers. Imagine a community with one bank, and that bank has 10 million in loans. Now the usual rules dictate that the bank should have at least a 1 million in equity as a cushion because, face it, lending has a tendency to have its bad cycles. The other 9 million is financed by deposits.
Now let's say another party comes to the bank and offers to take the credit risk on all 10 million of the bank's loans, in what is essentially a blanket credit default swap on their loans. The bank now views its operation as essentially risk-free (ignoring liquidity risk), so their equity cushion doesn't matter. But shouldn't the new counter-party now be required to have a 1 million equity cushion in case things go bad, since they are supposed to be the first and only line of defense? I think the answer to that is yes.
The problem is I haven't seen that. Look at Fannie Mae. At September 30, 2007, they had 2.8 trillion in total mortgage assets and guarantees. But their balance sheet had total capital of only 49 billion, or 1.75% of total obligations. If it were looked at like a bank, that would be an asset-equity ratio of over 50-1. That doesn't leave much margin of safety at all.
Am I missing something?