In a Word - Disgustipating!!

I am truly disgusted. The Inspector General of the Federal Reserve Board of Governors cannot tell us where the trillions went. And those that might be able to tell us aren't willing to talk. Just disgustipating!

http://www.nakedcapitalism.com/2009/05/federal-reserve-inspector-general.html

CDS Purgatory!

I have read a few posts over time - and written a few myself - on some of the problems with credit default swaps (CDSs). One of the problems that I have reported is that CDSs act like insurance against credit defaults but, guess what, you do not have something all insurance companies require - an insurable interest. Specifically, if I want to insure my house, no problem because I own it. If I want to insure my neighbor's house, problem. I don't own it and have no insurable interest in it. Yet in the CDS world, the insurers - issuers of the protection - don't seem to care if you have an insurable interest so long as you are willing to pay a premium. So I can insure my neighbor's house, as can everyone in the neighborhood, so when it burns to the ground we will have a party. In the financial markets this means people buying many trillions of default protection against risk they do not have.

Mind you, there is nothing illegal about this or for that matter immoral. It is more business as usual. Yet as with other financial instruments of current vintage, these carry some problems. For example, when a given company has a default event, $100 million in debt may have a billion in protection insuring it. Now the good news is that there are spirals.

What are spirals you ask? Well I do insurance and reinsurance litigation and we ran into this in London in the 1990s with worker's comp policies. Basically, A reinsured B who passed the risk to C who passed it to D who passed it back to A and so it then went back to B and so forth until someone passes it out of the spiral to fall guy. It is a bit different in the CDS world. What happens is A, B, C and D all sold each other CDS protection and now they realize they can cancel out offsetting positions. This process has successfully lowered nominal CDS outstanding values of an estimated $62 trillion (yes, several times global GDP) to - last I saw - about half that. Still a lot, but improvement.

Yet this story is not about this problem with CDSs. It is about a different problem with CDSs that apparently no one anticipated. Let's just say I have $10 million in bonds from Company Z. I am looking to buy CDS protection on that as it is cheap, so why not. I spend, let's say $100,000 up front and another $10,000 a year for five years to protect my bond position. Now the recession hits and Company Z is on the ropes. So much so that it is looking for major concessions from bondholders - like a 70% haircut - to avoid bankruptcy. But if I have insurance for the default, why would I agree to a haircut?

Couple of points to add here. First, when Company Z starts to get into trouble that may trigger collateral requirements on the CDS positions. These contracts are off the grid and individually negotiated so they can say whatever the parties want, but collateral requirements are not rare. Indeed, collateral requirements on CDS positions were a major contributor to AIG's demise. Second, I question to what extent the CDS providers - the people with the risk - are seeking to assert themselves into the shoes of the CDS holder in situations where the holder can take 70 cents on the dollar - basically an assignment or subrogation. If they are not just taking over the credit position, or cannot do so, the buyer of the protection potentially can force Company Z into bankruptcy, get full payment on the CDS and then let the issuer of the CDS stand in line for far fewer cents on the dollar. This is not good for the CDS issuer.

What a wicked web we weave!!

http://www.nakedcapitalism.com/2009/05/credit-default-swaps-holders-likely-to.html

Disclosures: None.