The question is whether CDSes are the last huge bubble left to pop, and how much further economic damage that will cause. After being vaguely aware of CDS issues but not anything like alarmed, my fears were stoked on November 24 by a report on one of the blogs I find indispensable in following the financial mess, Barry Ritholz's The Big Picture. The report featured an analyis by Chris Whalen of Institutional Risk Analytics, a guy (and firm) I've never heard of but whose analysis seemed plausible enough to frighten me.
It started by filling in the blanks on AIG, because I had not understood what all that money going into AIG's black hole was being used for. Had you?
Whalen: "Few observers outside Wall Street understand that the hundreds of billions of dollars pumped into AIG by the Fed of NY and Treasury, funds used to keep the creditors from a default, has been used to fund the payout at face value of credit default swap contracts or “CDS,” insurance written by AIG against senior traunches of collateralized debt obligations or “CDOs.” The Paulson/Geithner model for dealing with troubled financial institutions such as AIG with net unfunded obligations to pay CDS contracts seems to be to simply provide the needed liquidity and hope for the best."
I guess I had vaguely known we were bailing out gambling activities (which is how CDSes strike me) but hadn't focused on the fact that so much of the federal money is being used to honor these CDSes, or, more precisely, the collateral calls AIG faces as they go south.
Then Whalen had this chilling scenario:
1) Start with the $50 trillion or so in extant CDS.
2) Assume that as default rates for all types of collateral rise over next 24-36 months, 40% of the $50 trillion in CDS goes into the money. That is $20 trillion gross notional of CDS which must be funded.
3) Now assume a 25% recovery rate against that portion of all CDS that goes into the money.
4) That leaves you with a $15 trillion net amount that must be paid by providers of protection in CDS. And remember, a 40% in the money assumption for CDS is VERY conservative. The rise in loss rates for all type of collateral over the next 24 months could easily make the portion of CDS in the money grow to more like 60-70%. That is $40 plus trillion in notional payments vs. a recovery rate in single digits.
Q: Does anybody really believe that the global central banks and the politicians that stand behind them are going to provide the liquidity to fund $15 trillion or more in CDS payouts? Remember, only a small portion of these positions are actually hedging exposure in the form of the underlying securities. The rest are speculative, in some cases 10, 20 of 30 times the underlying basis. Yet the position taken by Treasury Secretary Paulson and implemented by Tim Geithner (and the Fed Board in Washington, to be fair) is that these leveraged wagers should be paid in full.
Our answer to this cowardly view is that AIG needs to be put into bankruptcy. As we wrote on TheBigPicture over the weekend, we’ll take our cue from NY State Insurance Commissioner Eric Dinalo and stipulate that we pay true hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches and pitchforks catch up to them.
President-elect Obama and the American people have a choice: embrace financial sanity and safety and soundness by deflating the last, biggest speculative bubble using the time-tested mechanism of insolvency. Or we can muddle along for the next decade or more, using the Paulson/Geithner model of financial rescue for the AIG CDS Ponzi scheme and embrace the Japanese model of economic stagnation.
(Whalen's whole post is here if you want to read for yourself).
Every since reading this I've been asking smart financial people if they think he's right and CDS is the Next Huge Awful Shoe To Drop. First I asked Pete Peterson and Robert Greifeld, who runs the NASDAQ, on a panel at the Fortune 500 Forum in Washington last week. Pete seemed to think this was serious stuff; Greifield agreed but felt the amounts were likely overstated. But I didn't take comfort from their body language.
Then I asked Alan Blinder at Princeton when in his office last Friday. Blinder agreed it was serious but it was hard to know just how serious. When he was at the Fed in the 90s, he said, they developed a rule of thumb, which may or may not apply in today's situation, to discount the "notional value" of outstanding CDSes to real exposure (after netting out, for example, contracts through which some firms bet on both sides of the same development). Back then they reckoned that 4% of the notional value represented real risk.
If that rule of thumb held today we'd thus be looking at around $2 trillion of potential losses governments could be asked to bail out, not $15 trillion. This is what passes for good news nowadays!
The truth is no one knows. Presumably the Obama team has to have a handle on this or they can't think intelligently about where we go from here. But the problem is that because these instruments are unregulated there's no one place to get a handle on the exposure. Tim Geithner & Co ought to immediately (like, by close of business today) require an inventory of this exposure. I'd like to think this was happening -- but after all we've been through, who can assume anything sensible is happening? The big question is whether this is manageable without, as Whalen suggests, some form of massive multi-firm bankruptcy reorganization that puts these instruments behind us, once and for all.
I'll keep asking folks. But in the meantime, why haven't the WSJ and NYT gone after this last big bubble with the full court press it deserves?