This article is a guest blogger submission written by KMC of Advanced Personal Finance. If you like what you see, why not subscribe to his RSS feed?

There’s an interesting wrinkle developing in the ongoing housing bubble/sub-prime saga. It looks like many large banks may be coming to the rescue of defaulting borrowers. Why would they do something like that? Because it lets them avoid huge payouts to hedge funds.

Credit Default Swaps

There’s a common derivative called a Credit Default Swap (CDS). It’s essentially an insurance property against mortgage defaults. A Mortgage Backed Security (MBS) is sold by a bank to a hedge fund (or anyone else). To hedge the exposure, the fund buys a CDS that pays off big if certain default criteria are met. Interestingly, the hedge fund doesn’t even have to own the MBS to buy the swap. Kind of like taking out a life insurance policy on someone else with you as the beneficiary.

So what we have is banks lending money per their normal business model. But because they’ve also sold CDSs, they really, really, really don’t want people to default on their mortgages. If enough do, the bank will be on the hook for serious cash.

What’s a mega-bank to do? Help out the borrower, of course. Banks are rewriting loans to borrowers at risk of defaulting in an effort to prevent the default criteria from being met.

Market manipulation or good banking practices?

Hedge funds and other purchasers of CDSs are naturally not pleased with this development. They’re arguing banks shouldn’t be able to do this to avoid paying on the swaps. The hedge funds call it market manipulation. Banks say they’re doing nothing of the kind, they’re just trying to help the little guy keep his or her home.

Hedge funds have a real problem here for precisely the same reason they normally the freedom they do – they’re very lightly regulated. There’s no governing body to make the decision on whether what the banks are doing is ok or not.

So if you read or hear about banks benevolently reworking loan terms for at-risk borrowers, now you know that they’re not doing it out of the goodness of their hearts.

But you already knew that, didn’t you?