Read the following. I came across it at Barry Ritholtz's blog, 'The Big Picture.' I have only a few comments at the bottom. But if you get the gist of it, I'll be surprised if you aren't startled. I was. So, go ahead, you should read it. The big question is what to think of it.
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.
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 [credit default swaps], 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 [this refers to the credit default swap market that is approximately $50 trillion].
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.
What do you think? How does the US economy go forward in light of the existence of an unregulated $50 rillion dollar credit defualt market? Bankruptcy, then new regulations, sound good to me. But really, who knows?
This is the problem with completely unregulated financial markets. Regulation is important becuase it is a way to collect knowledge about behavior. With no regulation, we have no knowledge. This situation looks ripe for change.