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Tuesday, November 18, 2008

 

CDS funding disaster revisited


i linked to the institutional risk analyst's recent missive regarding the collateral posting requirements of credit default swaps and the role CDS have played in sucking the liquidity out of the global financial system.

chris whalen revisits this theme in interviewing bill janeway.

the credit default swap has become what i would consider the hidden epicenter of the global crisis to correspond to the more visible warzone in CDOs, together comprising the coup de grace of what janeway calls "the greatest mountain of leverage that the world has ever seen."

[L]ast week Bloomberg News published a very important article talking about Brooksley Born, the former chairwoman of the CFTC and now a retired partner at Arnold & Porter law firm. The behavior of Summers and Greenspan over a decade ago in personally attacking and smearing Born when she dared to suggest that OTC derivatives might pose a systemic threat to the global economy enabled the explosive growth of the OTC derivatives markets.

Today there are over $50 trillion in outstanding credit default derivatives contracts, for example, contracts which must be funded by the global financial system as default rates rise and credit recovery rates fall. As we have written previously funding these CDS contracts as they move into the money may become an oppressive drain of liquidity from financial institutions and the global economy.

Meanwhile, last week Treasury Secretary Hank Paulson, finally admitted that his asset purchase idea was DOA. Although Paulson had sold the Congress on the bailout proposal based on purchases of assets, he has finally come around to the view we and others have been espousing for months, namely that capital injections into solvent banks is the first, best use for the bailout funds. But it may not be the only use for the bailout funds provided by the Congress.

As we shall be discussing in our comments at the Risk Management Association this Thursday in New York, we may actually need an asset purchase program after all, but not as originally envisioned by the Congress or the Bush Administration. Instead of a vague, voluntary program to allow banks to tender assets to the Treasury, we believe that the Congress must eventually legislate a mandatory exchange program to remove all of the extant CDS and complex structured assets from the global financial system. So serious and enduring are the negative effects of financial cancers such as CDS and complex structured assets, in our view, that the only way to save the patient - that is, the global economy and financial system - is mandatory surgery.


UPDATE: fil zucchi at minyanville notes that a similar line of thought has emerged in the senate.

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