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Tuesday, February 12, 2008

 

systemic financial crisis


i'm not forecasting it -- i can't. but that the scenario is being bantered around is sign either of a bottom or some really smart economists and commenters.

the estimable nouriel roubini blogged recently about what a sytemic financial crisis would look like, and clarifies that he's talking about something in league with what carmen reinhart and ken rogoff are examining. forbes relates the outline.

minyanville too hasn't been shy about drawing the perimeter of the worst case. satyajit das, bennet sedacca and rob roy all addressed credit default swaps today, with a view toward this being the end of the debt supercycle. mish shedlock thinks the worst, while perhaps not imminent, is unavoidable and squarely before us.

most everyone posits the downgrade of the monolines as the trigger that sets powerful accounting mechanisms into motion. but the power of the event is now so well telegraphed -- is there anyone in the marketplace that doesn't understand what could be coming? -- that it's probably become unlikely. jeff at dash of insight again says what is likely true.

The issue of the monoline insurance companies is a key question for markets, as we have noted. The process of "solving" this problem seems very slow to market participants. Daily trading reflects each twist and turn.

This problem will be addressed, either through private action or more aggressive moves by government agencies. The reason is simple. There is so much systemic risk.

Our opinion does not mean that specific companies or their investors will profit. In fact, the solutions may involve major dilutions of interest. Government is less interested in saving investors in the individual companies, but much more interested in stabilizing the economy and the markets.


what came today from warren buffett is not a fix for this problem -- indeed, it may be an aggravation. but the eventuality of a bailout, be it public or private, to fortify the credit default swap market remains a likelihood.

what comes after that -- particularly if a severe recession hits the united states and, as mish postulates, actual defaults start triggering CDS claims... that's another issue entirely, but at least it is one that remains down the road.

UPDATE: more talk of systemic risk reflected in the CDO market through ft and alea.

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I disagree. The monolines are economically irrelevant. Municipalities are selling bonds without insurance. If the monolines disappeared tomorrow, the only people who would notice are the rating agencies, bank regulators and some frightened old people who buy insured muni bonds.

 
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i completely agree, ia, that in the longer run the muni insurance industry is something of a scam. i think bill gross pointed out recently the fundamentally ludicrous nature of the idea that a company like MBIA can insure the bonds issued by the state of california, for example, with all its taxing power. there may be a role for it, but a much smaller one going forward and i suspect one which will be dominated by berkshire hathaway.

monoline downgrades will have an effect in munis, however, insofaras insurance took the legwork out of muni investing for a lot of people. people will have to differentiate between issues again, which is probably a good thing. a number of money and pension funds are also restricted from holding less than triple-a, and so will have to sell into illiquidity, probably at significant short-run realized losses. some poorly positioned money funds may have to break the buck.

but where the systemic risk lies is not in the muni insurance element of the book for these companies but in the CDS book. the monolines are counterparty to an estimated 70% of the CDS held by money center banks. if they default and cannot be expected to pay out on corporate defaults, the banks are faced with unbalanced derivative books and will have to start taking writedowns on them with one hand while furiously trying to engage in new CDS to restore their net credit position. that would be a very turbulent event in credit markets, and is indeed a potential trigger for a systemic collapse.

 
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yves smith at naked capitalism (now added to blogroll) has been doing an excellent cover of this issue -- this is a post i dug up over there outlining the nature and extent of the problem.

 
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