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Tuesday, December 02, 2008


2009: all about CDS

chris whalen of the institutional risk analyst proffers his outlook for the year to come, much in line with his recent analysis of the systemic funding and delevering crisis.

Today we make another prediction: that the unwind of Wall Street's rancid leverage pile will dominate the economic and political scene in 2009, both in the US and around the world. The chief engine of that deleveraging will be CDS, the vast, unregulated market in leveraged bets fostered and encouraged over two decades by former Fed Chairman Alan Greenspan and the academic economists who populate the Fed staff in Washington.

as noted by yves smith, a central revelation in whalen's analysis is that credit default swap dealer banks, such as jpmorgan chase and citigroup, have broadly not posted collateral with one another as CDS have gone against them. moreover, as no real and respectable estimation of probabilities of default have been made by CDS traders, estimates for which have instead been implied from volatility, leverage in the CDS market built up in the long period of low volatility which ended last year is far greater than it should be -- all but ensuring that many counterparties will fail.

the result could ultimately look like a system of AIG's -- as dealer counterparties in this new environment start to demand collateral of each other and as CDS actually trigger as a result of events of default, the funding requirements for CDS portfolios around the financial world would continue to suck liquidity out of the system. this forces all parties to hoard cash, and will send those many who cannot find sufficient funding to finally be rescued or go bust.

but the extent of the problem is, according to whalen's contacts, so large that EU governments are not capable of bailing out the most affected euro institutions without first stepping in and declaring a moratorium on CDS payments, which are coming due for large euro banks in the first quarter. that would likely precipitate a complete disaster in the CDS market, and effectively end OTC credit default swaps -- as whalen says, "the beginning of the end of the CDS market as we have known it will be at hand."

what will that mean? whalen:

the OTC derivatives market will implode and these unfunded liabilities may very well force the nationalization/liquidation of C, JPM and AIG, among others. And in the event, Hank Paulson, Tim Geithner, Alan Greenspan, Ben Bernanke and other senior officials at the Fed in Washington are going to have a lot of explaining to do to the Congress, to a new President and the global financial community.

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So, in a word, more deflation?

Ok, that's two words, but am I understanding this correctly?

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i think so, anon. it's important to see a CDS collapse in light of the synthetic CDO, which is a mimic created of CDS to satisfy what was once rampant demand for triple-A rated CDOs -- not least from banks, which are stuffed with the shit.

if a CDS moratorium is installed, these things are worth zero, and a monster pile of leverage based on synthetic CDOs as the underlying collateral comes crashing down.

enter wholesale nationalization, one presumes, of the entire american payments system, probably including most pension funds and insurance companies. if we think we're seeing a balance sheet recession now, wait until this comes down.

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Nice blog. If I understand this correctly, this would lead to a drop in price of bond ETFs such as AGG?


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rb, i would postulate that, to the extent that there is no CDS moratorium declared, major money center banks will shrivel up and die or be rescued. and, to the extent that one is declared, their entire synth CDO book is worthless, in which case they will shrivel up and die or be rescued.

as to AGG, it looks to me (and i just looked this moment, so please correct me) like this is mostly intermediate-duration treasuries and agencies. i wouldn't expect this to be the biggest problem area short of a currency crisis in the dollar.

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Actually, I don't understand all this well, but during the credit freeze of October, AGG dropped 10% in two days. itulip had an interesting interview describing how the patient (big banks) is dead because of CDS:


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