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Friday, December 12, 2008


treasury will finance automakers

per bloomberg. put aside for a moment whether or not treasury should be funding that which congress explicitly won't -- although the continuing transfer of the power of the purse form the legislative to the executive is being laid bare before the world by the crisis.

rather, consider the synthetic CDO disaster that may (or may not) have just been narrowly averted. more from option armageddon, expanding on the insights of the institutional risk analyst and chris whalen.

[N]ews about AIG reveals that the current problem with CDS has very little to do with the nature of the market and negative economic incentives, but with how the contracts work. As Martin Mayer says, it’s the plumbing, not the principals, that matters most. AIG does not seem to have lost all that much money, or I should say does not seem to have handed it over to counterparties. Rather, as the nature of the bad bets AIG made became clear the insurance giant has been forced to post larger and larger amounts of cash in collateral accounts to prove that it can pay its CDS obligations if in fact the underlying companies do default.

The money is not gone, it’s just stuck waiting for things to get better or get worse. Sure eventual payouts might be needed and that would be bad for those who have to pay, but then at least the money could be put back to work by those on the receiving end. Right now CDS seems to be working as a big liquidity sponge, sucking up cash into collateral accounts and keeping it from greasing the economy. This is likely happening to everyone, though on a scale smaller than AIG.

What’s interesting about all this is that the collateral positing requirements of a CDS contract are basically self-imposed capital adequacy requirements between parties to a CDS trade (great book on regulating capital here). Capital adequacy requirements have long been considered the brakes on the global economic locomotive. They keep banks from betting too big when times are good. And, if managed properly, they are reduced during bad times so banks can pull the cork out and lend, lend, lend. One of the big fears with CDS is that there really were no capital adequacy requirements. To a certain extent this is true, because nobody checks to make sure a counterparty can post the collateral when it’s due. The collateral requirements of CDS contracts, however, act like capital adequacy requirements. As it becomes likely that a CDS contract will have to be paid out, collateral requirements, er, require that protection sellers have more cash on hand.

If collateral posting is forcing cash into collateral accounts that otherwise could be used to make loans, we have a problem. And that problem is likely to get worse as more debtors become unable to pay their bills, CDS spreads rise, and more cash needs to be posted as collateral. The CDS market seems basically to be a liquidity easting machine and if that’s true then all the lowering of rates and injection of dollars into banks won’t do much unless something is done to either a) reduce collateral requirements on CDS trades (what would that do to the CDS market?) b) improve the credit of all debtors, which would reduce CDS spreads and let money out of collateral accounts.

The CDS market seems to be set up to make things worse when they look bad by sucking cash out of a cash starved system. Not smart.

now we have since discovered that it isn't happening to everyone all the time -- CDS dealer banks don't post collateral between one another, which means their potential liquidity issues are still ahead of them. but beyond single-name CDS it is critical to realize that, as kimball noted, "DTCC completely ignores CDO-related CDS, perhaps 40% of the market." and the automakers are named in a huge proportion of them.

The bailout of AIG represents the last desperate rearguard action by the CDS dealers and the happy squirrels at ISDA, the keepers of the flame of Wall Street financial engineering. Hopefully somebody will pull President-elect Obama aside and give him the facts on this mess before reality bites us all in the collective arse with, say, a bankruptcy filing by GM.

You see, there are trillions of dollars in outstanding CDS contracts for the Big Three automakers, their suppliers and financing vehicles. A filing by GM is not only going to put the real economy into cardiac arrest but will also start a chain reaction meltdown in the CDS markets as other automakers, vendors and finance units like GMAC are also sucked into the quicksand of bankruptcy. You knew when the vendor insurers pulled back from GM a few weeks ago that the jig was up.

... As Bloomberg News reported in August: "A default by one of the automakers would trigger writedowns and losses in the $1.2 trillion market for collateralized debt obligations that pool derivatives linked to corporate debt… Credit-default swaps on GM and Ford were included in more than 80 percent of CDOs created before they lost their investment-grade debt rankings in 2005, according to data compiled by Standard & Poor's."

should they trigger, the losses in synthetic CDOs will be massive.

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Bank of America and Mr. Higgins missing $millions, It can happen to you, my fellow Americans

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