What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup
Chris Whalen
November 24, 2008

Christopher Whalen is Managing Director of IRA. Chris has worked as an investment banker, research analyst and journalist for more than two decades. After graduating from Villanova University in 1981, Chris worked for the U.S. House of Representatives and then as a management trainee at the Federal Reserve Bank of New York, where he worked in the bank supervision and foreign exchange departments. Chris subsequently worked in the fixed income department of Bear, Stearns & Co, in London. After moving back to the U.S. in 1988, Chris spent a decade providing risk management and loan workout services to multinational companies and government agencies. In 1997, Chris worked as an investment banker in the M&A Group of Bear, Stearns & Co.


On Friday, the FDIC closed and facilitated the sale of two CA savings banks, Downey Savings and Loan, the bank unit of Downey Financial Corp (NYSE:DSL) and PFF Bank and Trust, Pomona, CA. All deposit accounts and all loans of both banks have been transferred to U.S. Bank, NA, lead bank unit of US Bancorp (NYSE:USB). All former Downey and PFF Bank branches reopen for business today as branches of U.S. Bank.

Earlier this year we wrote positively about Downey and the funding advantages it had over larger thrifts such as Washington Mutual due to the solid deposit base and strong capital. Indeed, as of Q3 2008, the bank’s Tier One leverage ratio was over 7.5%, more than two points over the minimum, and its charge offs had actually fallen compared with the gruesome 400 basis points of default reported in the previous period.

But since the September resolution of WaMu and Wachovia, the FDIC, it seems, is not willing to wait to resolve institutions, even banks that are apparently solvent and not below any of the traditional regulatory triggers for closure. The visible public metrics indicating soundness did not dissuade the Office of Thrift Supervision and FDIC from seizing both banks and selling them to USB.

The purchase of Downey and PFF is good news for the depositors and borrowers, who will all be offered the FDIC’s prepackaged IndyMac mortgage modification program as a condition of the USB acquisition. Bad news for the investors and creditors, who now see their already impaired investments wiped out.

The resolution of Downey illustrates both the best and the worst aspects of the government’s remediation efforts. On the one hand, we have argued that the government should be pushing bad banks into the arms of stronger banks to improve the overall condition of the system. The good people at the FDIC do that very well – when politics does not intervene.

In the case of Downey and PFF, it appears that the OTS and FDIC projected forward from the current above-peer loss rates and concluded that a prompt resolution was required. Reasonable people can argue whether this is the right call. But when we see the equity and debt holders of DSL, Washington Mutual or Lehman Brothers taking a total loss, we have to ask a basic question: why is it that the debt holders of Bear Stearns and AIG (NYSE:AIG) are granted salvation by the Federal Reserve Board and the US Treasury, but other investors are not?

If the rule of driving money to the strong banks (see “View from the Top: A Prime Solution to the US Banking Crisis”) safety and soundness is to be effective, it must be applied to all. And now you know why we have questions about the nomination of Tim Geithner to be the next Treasury Secretary. If you look at how the Fed and Treasury have handled the bailouts of Bear Stearns and AIG, a reasonable conclusion might be that the Paulson/Geithner model of political economy is rule by plutocrat. Facilitate a Fed bailout of the speculative elements of the financial world and their sponsors among the larger derivatives dealer banks, but leave the real economy to deal with the crisis via bankruptcy and liquidation. Thus Lehman, WaMu, Wachovia and Downey shareholders and creditors get the axe, but the bondholders and institutional counterparties of Bear and AIG do not.

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. Fed and AIG officials have even been attempting to purchase the CDOs insured by AIG in an attempt to tear up the CDS contracts. But these efforts only focus on a small part of AIG’s CDS book.

The Paulson/Geithner bailout model as manifest by the AIG situation is untenable and illustrates why President-elect Obama badly needs a new face at Treasury. A face with real financial credentials, somebody like Fannie Mae CEO Herb Allison. A banker with real world transactional experience, somebody who will know precisely how to deal with the last bubble that needs to be lanced – CDS.

Last Thursday, we gave a presentation to the New York Chapter of the Risk Management Association regarding the US banking sector and the long-term issues facing same. You can read a copy of the slides by clicking here.

As part of the presentation (Page 17-21), IRA co-founder Chris Whalen argued the case made by a reader of The IRA a week before (see “New Hope for Financial Economics: Interview with Bill Janeway,”) that until we rid the markets of CDS, there will be no restoring investor confidence in financial institutions. Here is how we presented the situation to about 200 finance and risk professionals in the auditorium of JPM last week. Of note, nobody in the audience argued.

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 queue 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.

And, yes, we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into a quick and final extinction. Remember, when AIG goes bankrupt the insurance units are taken over by NY, WI and put into statutory receiverships. Only the rancid CDS positions and financial engineering unit of AIG end up in bankruptcy. And fortunately we have a fine example of just how to do it in the bankruptcy of Lehman Brothers.

Our friends at Katten Muchin Rosenman in Chicago wrote last week in their excellent Client Advisory: “On November 13, 2008, Lehman Brothers Holdings Inc. and its U.S. affiliates in bankruptcy, including Lehman Brothers Special Financing and Lehman Brothers Commercial Paper (collectively, “Lehman”) filed a motion asking that certain expedited procedures be put in place to allow Lehman to assume, assign or terminate the thousands of executory derivative contracts to which they are a party. If Lehman’s motion is granted, counterparties to transactions that have not been terminated will have very little time to react and will likely find themselves with new counterparties and no further recourse to Lehman because, by assigning contracts to third parties, Lehman will effectively receive, by normal operation of the Bankruptcy Code, a novation.”

The bankruptcy court process also allows for parties to terminate or “rip up” CDS contracts, something that has also been fully enabled by the DTCC. The bankruptcy can dispose and the DTCC will confirm.

BTW, while you folks in the Big Media churned out hundreds of thousands of words last week waxing euphoric about the prospect for enhanced back office clearing of CDS contracts, the real issue is the festering credit situation in the front office. Truth is that the DTCC and the other dealers, working at the behest of Mr. Geithner, Gerry Corrigan and many others, have largely fixed the operational issues dogging the CDS markets. The danger of CDS is not a systemic blowup – though that will come soon enough. It is the normal operation of the now electronically enabled CDS market wherein lies the threat to the entire global financial system, this via the huge drain in liquidity illustrated above as CDS contracts are triggered by default events.

The only way to deal with this ridiculous Ponzi scheme is bankruptcy. The way to start that healing process, in our view, is by the Fed emulating the FDIC’s treatment of DSL, withdrawing financial support for AIG and pushing the company into the arms of the bankruptcy court. The eager buyers for the AIG insurance units, cleansed of liability via a receivership, will stretch around the block.

By embracing Geithner, President-elect Barack Obama is endorsing the ill-advised scheme to support AIG directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. News reports have already documented the ties between GS and AIG, and the backroom machinations by Paulson to get the deal done. This scheme to stay AIG’s resolution cannot possibly work and when it does collapse, Barak Obama and his administration will wear the blame due through their endorsement of Tim Geithner.

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 (NYSE: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.

And many of these CDS contracts were written two, three and four years ago, at annual spreads and upfront fees far smaller than the 90 plus percent payouts that will likely be required upon a GM default. That’s the dirty little secret we peripherally discussed in our interview last week with Bill Janeway, namely that most of these CDS contracts were never priced correctly to reflect the true probability of default. In a true insurance market with capital and reserve requirements, the spreads on CDS would be multiples of those demanded today for such highly correlated risks. Or to put it in fair value accounting terms, pricing CDS vs. the current yield on the underlying basis is a fool’s game. Truth is not beauty, price is not value.

If you assume a recovery value of say 20% against all of the CDS tied to the auto industry, directly and indirectly, that is a really big number. The spreads on GM today suggest recovery rates in single digits, making the potential cash payout on the CDS even larger.

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.”

At some point, Washington is going to be forced to accept that bankruptcy and liquidation, the harsh medicine used with other financial insolvencies, are the best ways to deal with the last, greatest bubble, namely the CDS market. When the end comes, it will effect some of the largest financial institutions in the world, chief among them Citigroup (NYSE:C), JPMorganChase (NYSE:JPM), GS and MS, as well as some large Euroland banks.

The impending blowback from a CDS unwind at less than face amount is one of the reasons that the financial markets have been pummeling the equity values of the larger banks last week. Any bank with a large derivatives trading book is likely to be mortally wounded as the CDS markets finally collapse. We don’t see problems with interest rate or currency contracts, by the way, only the great CDS Ponzi scheme is at issue – hopefully, if authorities around the world act with purpose on rendering extinct CDS contracts as they exist today. Call it a Christmas present to the entire world.

Indeed, as this issue of The IRA goes to press, news reports indicate that C is in talks with the Treasury for further financial support under the TARP, including a “bad bank” option to offload assets. [EDITOR: Already approved by Treasury and the Fed]. A bad bank approach may be a good model for applying the principle of receivership to the too-big-too fail mega institutions, but the cost is government control of these banks.

Q: Does a “bad bank” bailout for C by Treasury and FDIC qualify as a default under the ISDA protocols!?

We’ve been predicting that Treasury will eventually be in charge of C. On the day the government formally takes control, we say that Treasury should and hire FDIC to start selling branches and assets. Thus does the liquidation continue and we get closer to the bottom of the great unwind. Stay tuned.

Questions? Comments? info@institutionalriskanalytics.com



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Category: Bailouts, BP Cafe, Federal Reserve, Politics

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20 Responses to “What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup”

  1. olishiz says:

    Thanks Chris. I love the fact that you are addressing this. “everyone” else seems to like glossing it over. What a mess. And society is clueless once again.

    I love the solution, but with Geithner we will get “more of the same”. But I thought we voted for change?

  2. The Curmudgeon says:

    Excellent insights here. Essentially, let the markets figure out the prices that these obligations are worth, even if it means insolvency and bankruptcy. Yet, everything the government does or has done simply confuses the price picture, thereby extending the time necessary to get past the Ponzi scheme of investment banking/insurance that developed out of Greenspan’s easy money regime.

    What I don’t get in all this is how keeping AIG or Citi or GM afloat squares with the creative destruction necessary for a healthy economic system. Just because something has existed for a few years does not mean it should exist forever, or even for a few years more. AIG was not a CDS whore until lately. Neither was Citi a ludicrous off-balance sheet liability glutton. GM’s only been around a hundred years. Let them all fail. Burn down the old growth. It’s time for the cycle of economic life to start anew.

    The real problem is that we got too comfortable. But trying to avoid the discomfort and pain of creative destruction will yield even more discomfort and pain in the long run, once it becomes clear that these old-growth trees no longer bear fruit.

    That we just experienced one of the least serious presidential campaigns–electing someone that promised only an amorphous “hope” and “change”–speaks to the comfort with which we’ve deluded ourselves. The only change we got was in the person that wears the presidential suit. With Geitner’s appointment, it is clear that the new boss is the same as the old boss, enthusiastically commited to strangling the economy through defense of the status quo.

    Empires, be they economic or political, wax and wane. GM’s empire has been waning since the 50′s. The short-lived investment bank empire, built on bad risk assessment, has completely collapsed. Trying to forestall the inevitable just leaves fewer resources for building viable enterprises, and will ultimately destroy the political empire upon which our economic might is founded.

    These are sad days for America, but not because her economy is having some troubles. Rather, it is because we have forgotten how we got to this pinnacle of wealth and power that we enjoy. Giving good money to bad enterprises will soon enough destroy the money and thereby the empire.

  3. VennData says:

    The idea that Downey bank is not part and parcel of the speculators is incorrect. Downey and institutions like it in California, Nevada, Florida, Arizona, are the problem.

    The real use of the CDS system is for counter party risk on trades, prime brokerage etc. The flaw was that AAA firms weren’t obliged to post collateral. With only GE, BRK.A and few others left, this problem is taking care of itself. The powers that be (Bernanke, Paulson and Geithner’ et al) handling of this flaw in the CDS structure has been exemplary. They’ve done the right thing at the right time, the only balance sheet available to avoid liquidity-crushing collateral calls to AIG was the Treasury.

    The problem with the CDS market is that by offloading default risk while earn returns, arbitrage profits “existed” in credit markets. The CDS market, by removing default risk, allows credit investors to lever up more than is reasonable. This problem is also, gone. Moving to exchanges will only heighten transparency.

    When the CDS market does not “collapse” the author will be proven wrong and Geithner has done yeoman’s work for a decade plus.

  4. sellthekids says:

    thanks Barry for the link-up.

    second thing i read this morning after the WSJ’s “How Bearish Bets Hig Morgan Stanley” was the opinion piece across the fold by L. Gordon Crovitz: “When Even Good News Worsens a Panic”.

    from Gordo – “We now know that we should not have feared huge losses in the multitrillion-dollar, unregulated market for esoteric instruments called credit default swaps. Transactions in this market have been orderly, and the losses have been modest.”

    a little further on: “Congress has still not focused on how its policy of making mortgages too available led to unsustainable mortgage loans through Fannie Mae , Freddie Mac, and the Community Reinvestment Act that were the proximate cause of the credit collapse.”

    i’m used to the Opinion section of the WSJ being out of whack with reality, but i figured at some point they would get it. guess when the writer cites a speech by Wallison from the AEI i should have known what was up.

  5. bdg123 says:

    I see no rationale for supporting Geithner. None at all. This is a guy who got his start in the world by blowing Henry Kissinger – the most consummate of cronies. There is zero evidence of intellectual depth but rather a background of being groomed by the bureaucratic elite time and again to make his next move. To say that Geithner will be vindicated is absolutely hilarious. This guy sat at the head of the regulatory structure of Wall Street and didn’t peep a single word until the entire system imploded. Then in good bureaucratic form he ran around and gave speeches on the need for regulatory change. I don’t begrudge that but what it clearly validates is that he has little intellectual depth and no critical thinking skills. He was unable to see the mess he was creating while many in the world squawked at a coming crisis. He’s a political elite. A hack. He’s Wall Street’s lackey. As Portfolio states, he is perma-establishment. Is this who we really want running the Treasury in a crisis of confidence? A regulator who presided over the creation of the largest regulatory failure in history? Christ, intellectually he’s George Bush part deux.


  6. Andy Muldoon says:

    While Geithner’s nomination will be debated for a while, one thing that needs little debate is the exaggeration of the CDS time bomb. Please understand, I do not deny there is a problem with the CDS market, its structure, and the systemic risk it poses to the overall financial economy. However, I am amazed at the number of people who mistake notional, or gross, with net exposure. I remember just last month everyone was worried about Lehman’s CDS settlement. Some even used it as a reason why the credit markets froze up….banks were worried how much they would have to pay out. This turned out to be a near non-event, with something on the order of $5 billion exchanged. The notional numbers bandied about exceeded $400 billion. Now we are getting the same argument with F and GM. Even worse its being used as a reason to bail them out. The DTCC has quite a different number and its about $8-9 billion for each. I say let them fail or succeed on their own merits and if Congress insists on throwing money at the problem then let them cover the CDS losses.

    Link to the DTCC web page for company derivative exposure:

  7. winslow says:

    I like to get a perspective from many sources. The last several weeks, Jim Kramer has been explosive on why Geithner would be a very bad choice. His arguments had much validity. I really wish the powers-to-be would evaluate all possibilities. If so, Geithner would not have been selected. This was the problem we had with Bush…he had no capacity to make the best decision.

  8. backman says:

    Thanks, Chris. On some level this is the piece that we’ve all been waiting for–something that gives a clearer picture of the shadowy cds cloud that lurks behind every move in the market, and which constrains the government’s policy options without anyone actually acknowledging it. Clearly it would make more sense to let most of these entities slide into bankruptcy–that’s what bankruptcy is for–yet as long as the world of cds exposures remains too opaque even for the media to try to explain it, the taxpayers will continue to pay dearly for their ignorance as their pockets are picked dry by policy-makers in the Treasury and the FED. It’s awfully hard to imagine how Geithner brings a new direction here. It’s a very disappointing choice for a key position.

  9. creditdefaultswap says:

    How about a little comment on the DTCC CDS report that mortgage based securities CDS were nominal and that the largest face value CDS were on something like Italian governments, and that the Lehmann CDS settlement auction was a non event? Nevermind that GS is a major owner of DTCC. I am thinking a little backwards track of the synthetic CDOS sold to Wisconsin School Districts might be a faster lead to the major criminals. Too bad the CDS are all opaque.
    As an uninformed observer it seems to me the much much larger interest rate swaps have the potential for being the much larger elephant in the room as the yield curve twisted and the TEDs went nuts.
    So we have industry people saying there was 400B of CDS onLehman and 1000B+ on GM, and the DTCC
    saying the net was 6B on Lehman. Does anyone else have a problem with this?
    Is the OCC derivative report for Q3 always this late? Seems like GS and MS should have made it into the OCC report this time around.

  10. Winston Munn says:

    And now we have the Treasury, the FDIC, and the Fed writing what is in essence a CDS for Citigroup’s pool of $306B in CDOs.

  11. Neil C Denver says:

    Does anyone know the circumstances surrounding the exit of Donald H. Layton from JP Morgan Chase?

    At the time of his departure, he was in his mid 50s, was a Vice Chairman and a member of JPM’s three person Office of the Chairman and its Executive Committee. His expertise and responsibilities at JPM included capital markets and risk management.

    Is there a possibility that he was too conservative for JPM or did he resign at his own volition?

  12. Chris Whalen says:

    Thanks for these comments. On IR/Currency swaps, no I am not concerned because these are true money market instruments. These contracts provide an exchange of value between the parties and track the forward money markets. Not an issue, in my view.

    CDS on the other hand are “barrier options” to quote one of my buddies in the CDS world and really are fundamentally different from true swaps. Part of the reason I have done a Ritholtz past week on Paulson/Geithner is to use these technocrats as a canvass upon which to educate el pueblo on CDS.

    I am pretty sure the most of the US financial elite does not understand the degree of mis-pricing that exists throughout the markets, a problem now made acute as we skew the other way. But it all comes down to Alan Greenspan and the financial economists who populate the Fed staff not understanding the true nature of CDS, namely that it is insurance on highly correlated, that is, high beta risks. This is also, my view, why Citi and the other financials are under seige.

    The folks at ISDA used the legal and functional template of the IR/currency swap world to construct the Frankenstein Monster of CDS, but because what we are pricing is not a rate-driven exchange of cash flows or currency, but instead the probability of default, using bonds and their spreads as the underlying basis for pricing CDS is madness. That, in a nutshell, is the problem with CDS. The premiums of past five years were woefully inadequate to cover the normal default rates in a recession, much less the supranormal default rates we are seeing and will see for next couple of years. As one of my PRMIA colleagues said at an invitation-only CRO Summit last week sponsored by E&Y, we’ve never seen CDS go through a typical recession much less sustained downward trend in global GDP.


    Oh, I forgot. To the folks from Citigroup who keep calling me, asking to spend time discussing our analytical methodology and comments on CNBC today regarding Citi being in Open Bank Assistance and headed for full nationalization next year, Barack Obama as Chairman, etc., a couple of points.

    First, we do not publish Sell Side research, make recommendations or earnings estimates.

    Second, we have never been short Citi nor any other troubled bank.

    And finally, I’ll be happy to spend time with you, but you’ll pay our consulting rates and wait in line like everybody else.

    PS: Give our love to Raul Salinas de Gortari when you see him.

  13. jamestl says:


    Thank you for your piece but one of the things that I’ve been wondering about is your response to Andy Muldoon’s comment, namely that the gross notional value is irrelevant and the focus should be on the net exposure (which was small and manageable for the LEH settlement). I’d appreciate your comments on that. Thank you.

  14. Boomer108 says:

    Thanks, Chris, for your insights. Two questions:
    1) how do you square your 40% default rate with the $5b out of $400b in the Lehman case?
    2) didn’t banks hedge their exposure from the insurance they were writing?

  15. daniel k says:

    Why do so many comments refer to the CDS settlement results in regards to LEH…and not from the wild and growing total AIG has required from the govt? Just who is AIG paying with this money and for what CDS? Should be public knowledge.

  16. Chris Whalen says:

    OK, I’m done heaving my oatmeal into the trash can after seeing the photo of Obama, Geithner, Summers, and this lady I’ve never seen before. This is Rubin Summers II with two smiling minions. God help us. And God help our new president. I don’t care who you voted for, we don’t need to see this presidency fail when it comes to economic and financial policy.

    The issue with the gross vs net notional is important. Some of the $50 trillion notional is mitigated by netting, especially among dealers, but this does not mitigate the bilateral risk that remains between dealers and end users, both long and short. I have seen a lot of estimates one way and another, but to me if the net is say two zeros less than the gross, then why are we bailing out AIG and Goldman Sachs?

    A certain tall economist I know is quite worried about a default by GM and the resulting mess, a concern I share. That’s when we find out whether the gross or the net is important. GMAC will be right behind em.

    The $6 billion number from the Lehman auction, from what I understand, is the correct number for contracts that participated in the auction. I don’t think that number is comprehensive, but I cannot document the rest. We wrote about a certain German bank which did not participate in the cash settlement auction held by DTCC because they wanted the bonds. My personal view in the smooth process with Lehman results from a) the dealers are continuing to clean up the mess as funds with net obligations to pay die and b) it was not a huge issue in terms of CDS. But I don’t think we’re done with the Lehman CDS story, even after the bankruptcy court grants en mass novation as we described above.

    Agree on point on AIG. It is a black hole. A friend who worked with me at the Fed years ago asked an interesting question. AIG lost a lot of money on securities lending. Did AIG Financial Products borrow those bonds from another member of the AIG group? Maybe from the regulated insurance underwriter? Don’t know the answer, but happy to hear any comments from this thread in that regard.


  17. creditdefaultswap says:

    Thanks for the post and responses.

    My question on the interest rate swaps is directed more at the leverage and change in value on these swaps that has taken place over the last two months. What if the net value has changed 2 percent on the 600T notional swaps? ( or 300T or whatever DTCC is saying ), Assume everyone has a true hedge and has traded the same hedge 20 times, ok they are all netted to 0. In an era where counterparty risk is being contained only by the Fed supporting AIG and C, what if only 1 per cent of 6 trillion change in value is not hedged?

    My understanding is that not all I/C swaps provide an exchange of value between participants.
    My understanding is that some are used speculate on the future yield curve and are subject to a probability of mispricing calculations such as made by AIG, LMTC and others. Hello, we have not only had a Black Swan event in mortgages, CDS, etc etc, we have had a Black Swan event in interest rates and currencies.

  18. jamestl says:


    I don’t think anyone disagrees that there will be failed collections during a CDS settlement, the question is the magnitude of the failures. Since most of the CDS market is traded through dealers, presumably (and it’s a big leap of faith given what’s happened) the dealers were hedged on the trades and failures on either side approx. cancel each other out. The issue with AIG is that they became too big of a counter-party to the system and their failure would have caused all the dealers to go down, etc…

    I think the solution to the issue is what many having suggested, which is to move it on to an exchange. If that could be done efficiently and quickly, I think the CDS market will continue to exist. As a comp, the CME E-mini SP500 market is >$10 trillion in *notional* size (and this is just contracts on one index).

  19. Chris Whalen says:

    Thanks for the comment James.

    Point one: You are making one very common mistake, which is thinking that CDS is a SECURITIES type market where extant contracts are traded in a public, transparent marketplace. This is an INSURANCE market were pricing is a reflection of the willingness of one counterparty to write new contracts. Sometime these contracts are assigned to other parties, but that does not change the fact that most of the extant stock of paper does not trade. Merely fixing the clearing aspect or even having a central counterparty does not change this dynamic.

    Point Two: pricing. The current yield on the underlying bond is not an accurate way of pricing the default risk. That is why I believe it will be very hard to convince the clearinghouses to take the risk of being a central counterparty because the pricing of these contracts is all screwed up!! Remember, the central counterparty must stand behind all trades and they (and the clearing members of the exchange) will only do this if the contracts actually work in an economic sense. I submit that CDS is broken as a securities type model and will only work as an insurance product, with far higher “margin” requirements (i.e statutory reserves) and capital that is normal on a futures exchange. If you had to post a LC to demonstrate your ability to pay out on CDS, would you use the product? NFW.

    As defaults rise next 24 months, we’ll see this demonstrated — my view.


  20. Any news on the bucket shop front? I haven’t seen anything lately…