CDS, AIG & the rally in financials

For the uninitiated here is a Wikipedia snapshot of CDS:

"A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the specified events occur. However, there are a number of differences between CDS and insurance, for example:

-- the seller need not be a regulated entity;

-- in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;

-- The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. Generally, to purchase insurance the insured is expected to have an insurable interest such as owning a debt."

According to a Bloomberg report:

“Credit swaps were created by JPMorgan Chase & Co. more than a decade ago to hedge against losses from bank loans. As dealers made the contracts more standardized, hedge funds, insurance companies and asset managers began using them to speculate on the creditworthiness of companies, sending trading in the swaps up to $47 trillion in 2008, according to the latest data from the New York-based International Swaps and Derivatives Association. “

How CDS would incentivize more bankruptcy?

“Amusement-park operator Six Flags Inc. and automaker Ford Motor Co. may be pushed toward bankruptcy by bondholders trying to profit from credit-default swaps that protect against losses on their high-yield debt.

By employing a so-called negative-basis trade, investors could buy Six Flags bonds at 20.5 cents on the dollar and credit- default swaps at 71 cents. If the New York-based chain defaults, the creditors would receive the face value of the debt, minus costs. In a Feb. 27 note, Citigroup Inc.’s high-yield strategists put that profit at 6 percentage points, or $600,000 on a $10 million purchase.

Investors who bet on the collapse of a company are pitting themselves against traditional debt holders at a time when Moody’s Investors Service projects defaults will more than triple this year to the worst level since the Great Depression. The clash may stall restructuring efforts to prevent bankruptcies, as basis traders may be less inclined to participate in distressed debt exchanges….

“Before, you really had to worry mostly about where you were in the” company’s capital structure, he said. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy. It’s something that’s going to come up more and more.”

More here...

Why CDS holders can be paid ahead of bankruptcy creditors?

As per an informative article in TPM

"…the knowledgeable people already know this. But it turns out that one of the features of the US 2005 Bankruptcy bill was to put derivative counter parties at the front of the line ahead of other creditors in bankruptcy proceedings. Actually … they don't just go to the head of the line… They got to skip the line entirely. As the Financial Times noted last fall, "the 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company's assets until a court decides how to apportion them among creditors." As the article notes, ironically, this provision which Wall Street pushed for and got to protect investment banks actually ended up hastening the collapse of Lehman and Bear Stearns last year.”

Does it have anything to do with non-disclosure of AIG’s counterparties?

TPM explains it thus:

“If AIG were to go down, derivatives counterparties would be able to seize cash/collateral while other creditors and claimants would have to stand by and wait. Depending on how aggressive the insurance regulators in the hundreds of jurisdictions AIG operates have been, the subsidiaries might or might not have enough cash to stay afloat. If policyholders at AIG and other insurance companies started to cancel/cash in policies, there would definitely not be enough cash to pay them. Insurers would be forced to liquidate portfolios of equities and bonds into a collapsing market.

In other words, I don't think the fear was so much about the counterparties as about the smoking heap of rubble they would leave in their wake.

Additionally, naming AIG's counterparties without knowing/naming those counterparties' counterparties and clients would be at best useless and very likely dangerous. Let's say Geithner acknowledges that Big French Bank is a significant AIG counterparty. (Likely, but I have no direct knowledge.) BFB then issues a statement confirming this, but stating it was structuring deals for its clients, who bear all the risk on the deals, and who it can't name due to confidentiality clauses. Since everyone knows BFB specialized in setting up derivatives transactions for state-affiliated banks in Central and Eastern Europe, these already wobbly institutions start to face runs. In some cases this leads to actual riots in the streets, especially since the governments there don't have the reserves to help out. If you're Tim Geithner, do you risk it? Or do you grit your teeth and let a bunch of senators call you a scumbag for a few more hours?”

So what does all this mean?

According to various sources on the Internet:·

--- The recipients of the largesse appear to be Goldman Sachs, Morgan Stanley, Merrill Lynch and Deutsche Bank.

--- News and banks analysts’ reports suggested that Goldman Sachs got about $25 billion of the government bailout of AIG and that Merrill Lynch was the second largest benefactor of the government largesse.

--- The earlier payouts as per The Wall Street Journal of December, citing a confidential document and people familiar with the matter, revealed that about $19 billion of the payouts went to two dozen counterparties between the government bailout in mid-September and early November. As previously reported, nearly three-quarters went to a group of banks, including Société Générale SA ($4.8 billion), Goldman Sachs Group ($2.9 billion), Deutsche Bank AG ($2.9 billion), Credit Agricole SA's Calyon investment-banking unit ($1.8 billion), and Merrill Lynch & Co. ($1.3 billion), the Journal reported at the time. A lot more has been doled out since then.

More than $170bn. has been committed till now and the reason why more is being committed is becoming clearer. Apart from receiving bailout money directly these very ‘super-financial-organisms’ could have their financials dented further if this route was also not kept flowing. Normally these institutions would have received only pennies on dollar on the CDS if bankruptcy was allowed. So what the government is protecting is further loss of tangible equity of these ‘hearts’ of the global financial system which can keep the ‘blood’(funds) circulating – trying to avoid a much bigger and more unbearable blood on the street. If my understanding is correct AIG’s CDS obligations exceed $500bn. And with CDS incentivizing bankruptcies be prepared for much more than the $170 bn. committed.

But the flip side is that it is preventing these ‘hearts’ from a heart attack. Apart from the technical factors the current rally in financials has after all got a fundamental perspective too!!

Is there a way out?

This Market Watch report makes it an interesting reading:

…“Bernanke said the counterparties made "legal, legitimate, financial transactions" with AIG and presumed at the time that the contracts would remain private. "That is a consideration we have to take into account," he added.

Sen. Mark Warner, D-Va., suggested that AIG's counterparties should have to take a "haircut," rather than be made whole, because some of them probably didn't do enough due diligence on whether the insurer was financially strong enough to be selling such protection.

"In effect, what we're saying is, consequently, folks who bought these instruments and that, at some point in their process, should have been doing some level of credit analysis of what AIG was selling who didn't do that credit analysis are going to still come out whole for their lack of appropriate due diligence or responsible behavior," he said.

"I'm as unhappy as you are about that, senator," Bernanke replied. "I just don't know what to do about it."

Given the current rally in the financials one can only hope despite this treatment (the largesse) to prevent a ‘heart/s attack’, its side effects do not make it fatal.


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