Good Questions

The post about US Treasury CDS has garnered some great comments, including this one from Jill:

Every time you mention CDS, I am reminded of big Joe Cassano. I was in awe when it was disclosed that AIG had $78 billion of CDS exposure backed by subprime mortgages that allowed collateral calls when something dropped in value. And the guy made 300 million while working at AIG and then a million a month when hired back as a consultant after he resigned.

So this particular CDS on the 5 year Treasury note pays off when there is a loss in value or when there is an actual default?

Do you have to own the notes in order to purchase the CDS?

Wouldn’t the sellers of the CDS have their minions out there everyday on financial tv and in the press screaming warning of a default? Think of the money that will be made on the hype!

Who are the major sellers of CDS?

The CDS on Treasury bonds will be paid only if there is a default.  Loss in value is not a default.

Default will definitely happen if we fail to pay scheduled principal or interest on any bonds sold to the market.  If the “default” consists of failure to pay Medicare or Social Security obligations, there will be a massive debate about whether that triggers the CDS, which will be settled by the International Swap Dealers’ Association (ISDA).

The big change that occurred after the Dana Corp default was that people didn’t have to deliver the bonds (they call those “naked” CDS).  In subprime BBB bonds, the ratio of naked contracts to covered contracts was roughly 100-1 less than a year after the contracts were first traded.  Maybe you’d like to check out the chapter of my manuscript on the topic called “Invisible Leverage” or the simplified view on the absurdity of letting unknown speculators use up the credit of third parties in my post “Black Ice” from 2009.

The fact that buyers of CDS actually hurt the credit of those they bet against is one of the issues the market hasn’t really talked about, so I’m stealing my own thunder by saying that will be one of the issues addressed in the final installment of the series.

Back to your excellent comment, Jill.

First of all, that $78 billion was the visible part of the iceberg.  Before that margin call, there were many others, but AIG was the largest AAA financial company in the world, so they paid them.  And after that $78 billion was paid out by taxpayers (at 100 cents of the dollar while other insurers that were insolvent were settling for 10 cents on the dollar), more than $100 billion more in margin calls were paid.  It was a back door bailout in size for Goldman, SocGen, JP Morgan, Deutsche Bank and others that had held the “AAA” tranche of CDO’s they structured and sold, funding them using their bank capacity to borrow with government guarantees, but claiming the AIG “wrapper” kept them from having to hold capital.  If AIG had truly failed, all the banks would have failed, too, and then we’d find out that we taxpayers “sold” the insurance, in the sense that we paid the losses, but without getting the gains.

It was beyond absurd that the AIGFP people were paid an average of over $1 million each to stay there after they screwed up so badly.  After all, there were plenty of people left over from the merger of Bear and JP Morgan that knew the specialty, and another huge department available from Lehman in those scary days in late 2008.  In fact, AIG would probably not have gotten the bailout if they had failed before Lehman, but, as I pointed out in “Good Timing,” the issue of actually calculating the moneys owed in the system was already using everyone who could do it 24/7.

So how much exposure is there?  Answer:  More than the scariest numbers any of of the debt-screechers come up with when they extrapolate every bad trend forward for spending, Medicare and Social Security.  Many times that national debt.  Many times the GDP.  And it’s all concentrated in a few taxpayer-guaranteed banks.  In the US, just four banks have one side or the other in well over 90% of all the swaps and CDS outstanding.

Here’s the global picture, released two weeks ago by ISDA.  Naturally, they do everything they can to assuage the impact of these huge numbers, especially by taking into account “netting” where a bank has one contract on the bullish side of the trade with one counterparty, and another contract with another party that’s bearish.  It works until a really big counterparty fails, and then everybody becomes imbalanced all at the same time.  What fun!

Swap Market Analysis 12-21-2012

For those who don’t like analysis, even summaries like this, the truly awesome total of OTC (over-the-counter) derivatives contracts executed as swaps amounted to $639 trillion (with a T!) on June 30 last year.  Total credit exposure was “only” $25 trillion.

I’ll bet it makes you feel all warm and cozy knowing that those brilliant casino operators we call international banks have the situation so well under control.  Just in case my sarcasm wasn’t dripping off the screen enough, check out this summer’s London Whale case.  Or think about this — banks are finally starting to pay up for the fraud they committed in 2008 and 2009 by deliberately understating LIBOR.  In case anyone misses the significance of that, all $639 trillion of those swaps determine which party gets paid, and how much, every payment date on every swap using LIBOR as the basis of the payment.

It boggles the mind when you think how large this is compared to the real world.  And how much you and I and everyone else is “on the hook” if any of them screw up again and can’t cover the losses themselves.



3 Responses to Good Questions

  1. Robin says:

    Naked CDS’s should be illegal. They turn a legitimate hedging system into an obscenity.

    The cynic in me wonders how many CDS’s against the U.S. debt Mr. Cantor holds in untraceable offshore accounts….

  2. Jill says:

    Thank you for your response. The ISDA summary is truly mind numbing. I will certainly be keeping an eye on the “watch list”.

    A research paper in the Financial Review describes a default on some Treasury bills in 1979:

    “Because of severe technical difficulties, the U.S. government was unable to repay investors in Treasury bills (T-bills) in late April through early May, 1979. This incident led to a 60 basis point increase in T-bill rates at the initial occurrence of the default. Unlike other information effects of that era, such as Henry Kaufman’s predictions or Paul Volcker’s “Saturday night special,” this increase in rates was not offset by a subsequent decrease in rates after the Treasury cured the default. The default apparently warned investors that Treasury issues were not completely riskless, which translates into a $12 billion annual increase in federal interest payments as a result of the 60 basis point permanent increase in interest rates.”

    We are in for quite a ride these next three months. It seems that even a minor default as described in the above abstract will add fuel to the fire and exacerbate our debt problem even more. Good luck to us all.

    • hhill51 says:

      Now just imagine what the market penalty will be if the reason for the default is political capriciousness. It boggles the mind.

      And so does the misinformation campaign that has already begun, with multiple talking heads on the Sunday shows calling a purposeful default “a partial shutdown of the government”…. these people are dangerous!

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