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What will happen if the derivative markets collapse? This is the question we don’t seem to be asking in public. Maybe the answer is too scary. Take a deep breath and read this (thanks a lot, EW).

Remember the basics about credit default swaps. One side buys protection against loss on debt issued by a specified company or nation from the other. The buyer doesn’t even have to own the debt. It just pays a premium based on “market” assessment of risk. The seller gets the premium, and promises to pay the difference between the face value of the debt and the value at the date of a credit event, like bankruptcy or failure to make payments.

Take another deep breath. The ISDA gives the following estimate:

As of December 2007, gross mark-to-market value of all derivatives was approximately 2.4 percent of notional amount outstanding. In addition, net credit exposure (after netting but before collateral) is 0.5 percent of notional amount outstanding. Applying these percentages to the total ISDA Market Survey notional amount outstanding of $531.2 trillion as of June 30, 2008, gross credit exposure before netting is estimated to be $12.7 trillion and credit exposure after netting, but before collateral, is estimated to be $2.7 trillion.

Banks are big players in this stuff. Citigroup has a total portfolio of swaps of various kinds of a sickening $36.8tn. Oops, maybe another deep breath. The largest part of these are interest rate swaps, but it has sold $1.57tn and bought $1.67tn in notional amounts of CDSs, according to the chart on page 40 of Citi’s financial statements. The total portfolio of swaps is about 6.9% of all swaps outstanding.

If we take Citi’s portfolio profile to be reasonably like the overall market, which is reasonable because it’s so big, we could guess that its exposure to loss is .5% of the notional value of its portfolio, which is $184bn after netting and before application of collateral. Let’s hope it’s only that bad.

Citi is required to evaluate its portfolio of derivatives using FASB rules. Citi provides a table of mark-to-market values for its trading portfolio. This gives values of $165bn and $149bn. There is much uncertainty here. For example, if Citi has hedged its protection sales with protection purchases on the same reference entities, it has to guess how much it can collect from its counterparties. It has to estimate where the losses on protection sales will occur, and where its bets on protection purchases will pay off. That can’t be estimated easily, and Citi will use very conservative estimates internally. The financial statements are confusing on this point, as hedging, netting, and collateral are all lumped together for the entire portfolio of derivatives, including the enormous interest swap portfolio.

In an earlier diary, I suggested we impose a punitive tax on naked CDSs. Now I see that taxing won’t work. Most of the players in this market look like Citi, with both purchases and sales of protection. If we tax gains, there won’t be enough money for losers to pay winners, and the problem will be worse. A lot of gamblers are buyers and sellers, not on the same reference creditors, perhaps, and they will need money from the wins to pay off the losses. Crushing the transactions will also affect the ability of the sellers of protection to pay off on hedging transactions, which is probably important. For example, GM has used some of these to protect its pension plan.

Whalen offers another solution: make them all unenforceable. He suggests that one way to do this is bankruptcy of the big protection sellers, like AIG. He points out what we already know, that a lot of the money we sent to AIG is now posted as collateral with its CDS counterparties. How will we feel about this, he asks:

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.

Whalen thinks we should pay the hedging transactions in full, and pay pennies to the gamblers. Theoretically, this could be done in bankruptcy. In Chapter 11, the goal is to create a Plan of Reorganization which changes the obligations of the company to its creditors so that the reorganized company can succeed. The plan of reorganization would put hedging CDSs into one class, and naked CDSs into another. The hedge class would be paid close to par. The other would get a penny on the dollar. The plan has to be approved after a hearing in the bankruptcy court, and the gambling crowd will either eat the problem, or emerge from the shadows to object, which will expose their shabby game to national derision.

There are several big problems with this. First, when a bankruptcy is filed, there is usually an automatic stay, which stops creditors from taking action to obtain property of the Debtor. 11 U.S.C. §560 says that this doesn’t apply to swaps. Other sections of the Bankruptcy Code do the same thing about other derivatives. The effect of these provisions is hard to predict, but they will make it difficult to stop counterparties from making a big fuss and probably limiting the ability of the company to protect itself and real creditors from the wolves.

Second, this solution doesn’t solve the problem of gamblers who need their winnings to pay their losses. We may be bankrupting a whole lot of people and companies, and we won’t know who until the bankruptcies start. Finally, bankruptcy won’t work with banks and insurance companies that wrote CDSs themselves, as opposed to holding companies or sister companies. Notice that Citibank has written a bunch of protection. When banks and insurance companies go bankrupt, they are administered by the FDIC or the State Insurance Commissioner. In either case, there is a statutory order for payment of creditors, and it isn’t likely that a court can do much about that order.

I’m beginning to think that we should just terminate naked credit default swaps outright. Declare them illegal and unenforceable. This is just the first step, as there are loads of problems, like, what happened to the premiums.

Unfortunately, right now, the only people trying to come up with an answer are some fringe guys running around with their hair on fire. Our Masters in financial world are too busy demanding ransom from the government; they can’t be expected to acknowledge the problem, let alone deal with it.