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It looks like the Obama team is going to go with the bad bank idea. Meanwhile, nationalization is no longer just an hallucination of DFHs. Joseph Stiglitz is talking about it at CNN (drawing, I might add, a delightful collection of crazed libertarians in the comments.)
Today’s question: either way, what are Credit Default Swaps going to cost us?
The financial statements of Citi show a portfolio of CDSs consisting of $1.57tn in protection sold, and $1.67 in protection bought. See page 41. Bank of America shows $1.21tn in protection bought and $1.22tn in protection sold. See page 149.
The last round of financing to Bank of America, that last $100bn, was in large part due to problems with Merrill Lynch CDSs, according to Gretchen Morgenson in the NYT. If this is like what happened to AIG, Merrill Lynch had to post collateral for a huge amount of CDSs, and wasn’t able to without taxpayer assistance. So, for the second time we have been forced to save this worthless excuse for a market. There is no reason to believe it won’t get worse, and that Citi and BoA will have to put up more collateral, and we have no idea whether they can post it.
And to pile up the cash collateral already posted, players in the market had to sell billions in securities. Did that affect your 401K?
What will happen to the CDS portfolios of these behemoths if we nationalize them? Are we going to wind up paying off on some part of these bets? This is from Morgenson’s article:
While the amount of credit insurance outstanding is around $30 trillion, Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., says he believes fully half that amount isn’t problematic because it consists of winning and losing stakes that offset each other.
But that still leaves $15 trillion worth of contracts that may be in need of triage.
Suppose half of the portfolios at Citi and BoA are offsets. That leaves them exposed to half of their portfolios of protection sold, about $836bn at Citi and $612bn at BoA. That could be a ton of collateral, and when the reference entities fail, it’s gone. Even if the reference entities don’t fail, the collateral is tied up, and not available for lending. At the same time, the collateral posted to support the equally large portfolio of protection bought isn’t available for lending either.
So, the nationalization stuff looks to have serious downside. How about the bad bank? Does the FDIC plan on buying CDSs? We know that the problem at AIG was that it issued CDSs on collateralized debt obligations. The collateral in these instruments includes all sorts of stuff, like securities, bank loans, and, of course, mortgages, including sub-prime junk. When the CDOs soured, AIG couldn’t post the collateral, and we had to pony up. So we do need to worry if the Bad Bank decides to buy CDSs.
The problem with the Bad Bank is pricing the assets to be bought, just like it was with the initial plan for the TARP. Banks will pay lobbyists to insist that pricing of CDSs isn’t a problem, because there is a market. Here’s a description of that market from the Financial Times (H/T Calculated Risk):
David Goldman, an old friend and credit strategist turned private investor, still goes through the credit run sheets from the dealers. "The business looks like the window of a Brezhnev-era Soviet butcher shop. Mouldy scraps hanging in the window. Old women lining up at 4am to try and buy credit protection on General Motors. What are reported as trades are really ways to establish prices to satisfy the auditors."
Not only that, Citi and BoA are both market-makers and players in the CDS market. The “market” consists of a relatively small pool of speculators, hedge funds, and banks. Why would we have any confidence in those prices? The Financial Times article offers this story:
Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. "The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?"
I sure hope the Obama administration isn’t going all Hank Paulson on us.
71 Comments
Thanks masaccio, you cut to heart, as per usual
digg is open
What your post highlights is that partial fixes won’t work and that a comprehensive plan is needed.
A bad bank makes sense as part of a nationalization plan. Without one, it is just a scam, a way to dump crap assets on the government at elevated prices. Within a nationalization plan, the assets could be set closer to their true value, which would be their pre-bubble prices, or a cramdown of about 40% off their face value. Now such a valuation would show that most banks are insolvent. That’s OK within a nationalization plan because the government is there to backstop, reorganize, and recapitalize them. Outside of such a plan, we keep playing these endless episodes of the Emperor has no Clothes. The banks won’t make a truthful declaration because this would be an admission of their insolvency. So they continue to scheme to drop their toxic assets on us. And it should be noted that this has proceeded to such a point that even if many of them succeeded in doing so they simply won’t restart normal lending until they are forced to.
CDSs are another aspect of this problem and one where again a comprehensive plan is needed. CDSs as insurance without being insurance were always a bad idea. The way they were structured, the offsets all go to why they were such an insane idea. A CDS is a little like an insurance policy on your car where you could collect from your underwriter the full value of your car with no depreciation even after a few years on the basis of a flat tire. And not just you but your neighbors or somebody on the other side of the country or the world could also take the same insurance policy not their car but on yours, i.e naked CDSs.
But not to worry your underwriter could go and buy a CDS to cover their CDS and so the offset. The problem is that CDSs could be written on CDSs on CDSs ad infinitum. This process doesn’t spread out the risk as theory predicts it just makes it harder to follow. And through naked CDSs and the lack of amoritization of risk over the time of the CDS actually multiplies it.
Naked CDSs should be nullified. Equity backed CDSs after offsets should be settled on the basis of its value after amortization of risk and a 40%cramdown. So for example an outstanding equity backed CDS written 3 years ago for a 5 year period would be amortized to 2/5 or 40% of their value and with a 40% cramdown (leaving 60% of the underlying value) the settlement value of CDSs would be 24% of the face value.
Now when you consider that the government after nationalization would be the settler of CDSs. It would have a couple of options. The first is settle and keep the mortgages. The second is to sell off some or all of them or hold them until they could be sold for more. A third avenue would be to purchase the underlying mortgages, renegotiate them with the 40% cramdown, and prevent default on the CDO the CDS was written on.
You can vary the parameters or try something different but the idea is that CDSs can be unwound but only within the confines of a comprehensive plan.
The first question is whether the Administration has thought about this. The size of the portfolios represents a gigantic problem, even if most of them will settle cheap. Some part of the portfolio requires collateral, and no doubt some of it has collateral posted to support it. Where is that money? How much? We don’t know anything.
I think Obama may require legislation before proceeding either with nationalization or the aggregator debt. Dealing with the CDS problem should be part of the legislation.
Bwaahaa! For being experts with long careers in the field, you would think they would have, but experience keeps teaching us differently. They never seem to foresee anything. They never seem think through their plans on even a basic level. It’s kind of scary actually.
Wouldn’t you love to be a fly on the wall in those meetings with all those “experts” and Obama?
I think they are looking for the softest landing as opposed to a thundering crash where riots would begin IMMEDIATELY.
They want people to be completely demoralized with no fight in them so they want to draw this crash out slowly like dropping the lobster in the pot of cold water and turning the flame on.
Me too.
Larry Summers was one of the people in the Clinton administration, along with Ron Rubin and Alan Greenspan, who supported efforts to prevent regulation of derivatives, like CDSs. At least he knows they exist.
Bob Rubin.
Yep. All the usual suspects.
I’m willin’ to bet neither Stiglitz, Krugman nor Baker are there. Summers and Geithner will be there, though, with their “we need to give more money to Goldman Sachs, Citi, BoA and the other big boys.”
Don’t forget to kill all of Goldman Sachs’ enemies while you’re at it.
I ordered Depression Economics today. Should be here first week in Feb. Received Plunder and Blunder today. Slim little volume but a great primer on the stock and housing bubbles. Easy read.
I haven’t read Plunder & Blunder. Should I?
Prolly way below your knowledge level. I think it’s more for economic dummies like me. If you see it in a bookstore take a look.
Good suggestion.
i just ordered it, expect it to arrive tomorrow. have heard enough talks and interviews to be convinced to read it….
oops was thinking of the wrong book – i just ordered james galbraith’s predator state.
The very nature of capitalism is asset bubble creation. Whatever the underlying asset is, they inflate it and get people chghasing after it ginning up the value and making money in transactions and like musical chairs, they exit or short sell as it’s bursting and start a new bubble.
If you have enough power you can create the bubble and game the system. They never thought it through because there is always another bubble to create. In capitalism it is all about finance created asset bubbles. And it’s easy as pie to create them.
It’s the emperor and his clothes, but we now see he has none. YIKES
I meant aggregator bank, the name they are giving the Bad Bank.
What exactly is a bad bank?
All of them.
It’s the US Taxpayers, saddled with all of the liabilities – while the banksters who run this country steal as much money as you allow them to print.
They’ll probably just use the structure of the FDIC and dump all the toxic, totally worthless paper in there – which effectively bankrupts America.
Thank David Rockefeller and his New World Order Globalists from the CFR, Trilateral Commission, IMF and World Bank for destroying the global economy in order to enrich themselves and commit you to a life of slavery.
Take a look at this post. The idea is to form a bank that buys up the toxic assets, then works them off. The problem is what to pay for the assets. And, of course, what to do with the horrid assets of CDSs.
Yes, in my #2 above, I try to show how they could be valued. Since they are illiquid and the government is the only potential buyer, the government can set the price according to its own criteria.
Your idea for valuing CDSs is clever. We might want to treat naked CDSs differently from hedging transactions. There are a couple of other ideas in the Financial Times article.
Generally, I like the idea of wildly underpaying for the dreck, and then giving the sellers an interest in the Bad Bank. If we guessed wrong, they get a share of the profits. Then we look at the bank’s balance sheet, and either add TARP money for common stock, or let them collapse if they don’t look like they are going to be able to survive even with TARP money.
If you nationalize, the government can value the bank’s assets, separate out the bad stuff into a bad bank, and close or recapitalize the bank. It can also use the bank for cramdown refinancing of mortgages, re-initiating normal lending, and limiting bank size to avoid too big to fail entities. Yes, I have said this all a million times before.
Our biggest problem as Democrats is our unwillingness to repeat things over and over until everyone understands.
i will believe that is our biggest problem when i’ve heard the democrats say something worth repeating.
Good point.
LOL. i od’ed on watching the house “debate” the stimulus bill. the Rs were batshit crazy and the Ds were idiots. don’t know which were pissing me off the most.
Surely not all the banks would collapse if they are allowed to choke on their toxic assets. Some would survive. Obviously the first round of TARP ($350 billion) did nothing to loosen money for lending. It has been speculated that the 2nd 350 will not loosen money for lending. Many Merkuns have bad credit and can’t get a bank loan under any circumstances.
The focus is wrong. The focus should be on home mortgage borrowers who are in default. Lower their payments and extend the term.
hahahahahahahahahaha Mine is definitely one.
As Michael Jacko said
it’s bad it’s bad it’s really bad
If you were an errant bank, holding vast piles of questionable/worthless paper, and suddenly friends show up with large piles of TARP bail-out bucks, which of your ‘Troubled Assets’ would you sell them, the absolutely worthless, the conceivably worthless, or the possibly worth-something?
If I understand it properly, there is no way of knowing what we’re getting for our ‘investment’.
I would guess we’ve got nothing so far, we’ll probably never get to the conceivably worthless paper, since there’s so much absolutely worthless paper?
It seems very much like giving money to junkies, they’ll never stop coming back, and they look worse every time.
I suspect that there may be a bit of a tax payer’s revolt come 4.15
How can you buy “something” when you don’t know what it is? Is it in a seal envelope of something?
What about due diligence? Appraisals? Ratings? What are they selling?
There was a little
girlbankWho had a little curl
Right in the middle of her forehead.
And when she was good
She was very very good
And when she was bad
She was horrid.
In this instance, it is an entity that would be set up to hold and dispose of toxic assets. It is something like the Trust Resolution Corporation that was set up to deal to liquidate assets during the thrift crisis. But it is also different because most of the current assets don’t relate directly to underlying equity but the financial instruments based on them, i.e. the CDOs and CDSs. This makes their disposal a lot more problematic.
Stop asking questions about the structure and details. It’s not intended to be understood. Think Enron.
Want to know that’s really going on…stop looking at ground level – and fly on up to about 40,000 feet to connect the thousands of dots that explain the entire conspiracy.
Excellent advice.
It may have started in a small way with Clinton trying to help people buy homes. But, the Repubs had to crush that as they don’t want people to see any Dem policy as successful.
Economically it’s an attempt to pass a lot of crap through the system based on the hilariously inflated housing bubble prices on to the public. It’s a huge theft from the general public to the already obscenely Rich.
But, if everything falls apart we all lose. Naturally the thieves figure we’ll fight like the dickins to avoid that, so they’ll get their payoff.
What government has to decide first is whether this “bomb” can be defused before having to consider anything else. It’s not easy. Somebody devised a very very complicated mess.
If you can’t defuse it then you have to decide whether it’s better to let it explode or to pay ‘em off and hope to catch & jail ‘em later.
Various methods of trying to defuse the “bomb” are being considered now. I’ve suggested letting it mostly run it’s course, help fix mortgages as they foreclose and keep the financial system supported. But, the bankers refuse to lend even with help. What kind of criminal is it that takes your money and then asks for more? Heh.
I recently suggested that if we can’t stand the pressure, then we ought to use imminent domain to take all the toxic assets, yes just take them to protect the national (and world) economy. If we can fix them then we could sell them back into the market or just hold them in F&F. This will probably cause untold problems as the “bomb” has multiple aspects which are all nasty (Credit Default Swaps being one).
The other big option is to let it explode and destroy the economy and the dollar. Who wants to make that call? Talk about nasty consequences.
It might be that a political choice to do it while we have Dems in charge and can fix whatever happens would be good. Letting it linger and explode when Repubs come back into power would be nice in a traditional way, but in this case it probably gives them something they want. Just imagining the Crazies getting back into power is horrific in any event.
What would you do? plunger? Flush ‘em? heh
Mark: I would reveal the ENTIRE TRUTH about EVERYTHING, and I do mean EVERYTHING.
All of the co-conspirators at the highest global level have all of the money they’ve stolen somewhere. I’d reveal ever overlapping conspiracy to the people of all countries and use the available laws in all countries to prosecute these criminals to the fullest extent of the law AND GO GET THE MONEY BACK THAT THEY STOLE or otherwise received through the terror they employ to start the wars we fund.
All of the “money” we need to pay off all our debts and provide wonderful lives for our people exists. It’s just in the coffers of the international bankers who’ve stolen it. Start by arresting David Rockefeller and proceed from there.
Follow the evidence to the money.
Excellent piece, but too many trial balloons have already taken flight. The end game will be to take the Federal Reserve lock, stock and barrel under the wings of the US Treasury, it’s just a matter of time. Obama seems to have his head screwed on right, but only now is he outraged at the 18 billion in bonuses paid to Wall Streets elite? Seriously Obama, where have you been? Now for a bit of tongue in cheek. The bonuses didn’t help enough of those good folks, so as to lighten things up a bit, check out this little diddy.
http://www.youtube.com/watch?v=gwHRqusXauw
OK, let’s start a fund to get this put on during the Stupid Bowl. *g*
That is a good one.
Who would buy sh8t from a bad bank? I can see someone buying sh8t from a trusted bank, but it’s like walking into a “fencing” operation and buying stolen goods and fake rolexes. Who in their right mind would buy this crap?
What I am understanding is WE will by it from the banks so that they get some good clean cash and then they are supposed to act like nice little banks? And the band banks just fold… And we lose all the money since no one would buy the sh8t.
This is not rocket science.
We need more used car salesmen? No?
Absolutely but wouldn’t you like two hours, maybe even just one, to explain to Obama what is what and who is who with regard to the economy.
kind of a dead give away when none of them are being jailed but instead left in charge of these banks. At least in the rtc days these bastards got punished, now it’s an absurd joke.
Maybe they should allow people to buy stock in the bad bank instead of seeing tax breaks.
Good idea. Free CDS’s for all registered Republicans who clamor for tax cuts.
What % of the junk is owned by hedge funds? Those out to be zeroed out.
I’ve gone looking for that, but there is little information available. Here is the correct link to the Citi financial statements. I messed up the link in the text. If you look at the table on page 43, you see a couple of lines that might include hedge funds. It is just one more of the things we don’t know about this market.
Hedge funds are the last black box in the financial crisis. CDSs and CDOs have received some attention at least but hedge funds and their activities have largely flown under the radar. They have had huge losses but like the banks they can pretend they aren’t bankrupt as long as no one calls them on it.
Huge losses indeed, not only in their asset/trading activities, but in redemptions.
I assume you are thinking of the loans banks made to hedge funds to enable them to leverage up their investments. I wonder how much exposure Citi has to hedge funds. I have looked, and cannot identify any hedge funds among the largest 1000 largest reference entities on the DTCC warehousing reports.
from CR: $4 Trillion Bank Bailout?
that last line ought to be the running for understatement of the year.
By consumer debt I assume that’s credit card debt. Can Citi et al be holding so much bad credit card debt that by writing the worst of it off it would put them in jeopardy? If not, why would we underwrite their bad debt?
A huge amount of credit card debt is held in, you guessed it, collateralized debt obligations. These are usually called Asset Backed Securities. It is this stuff, probably tucked into other derivatives, that is most likely what the article is talking about.
Never thought of that. Thanks. Is there anything they didn’t put into this junk?
You know the joke is that Goldman keeps upping its number but I said an age ago to get a ballpark figure for mortgage losses all you had to do was take the size of the mortgage market ($12 trillion in the bubble) and figure how much (40%) you would need to roll it back to pre-bubble prices. My figure was $4.8 trillion. As I said a joke, they are a lot slower than I am but get paid a lot more. Go figure.
they aren’t paid to be right or fast. :(
Slightly OT:
Japan’s industrial output crashes
Time for some more bonuses and capital gains cuts.
Jane is upstairs at the Mothership!
I Am Become Rahm — Destroyer of Bipartisanship
Generous executive compensation, private jets, hookers and blow are required in any case. It is imperative to retain the braintrust. Opportunities in the government sector threaten to lure away the best and brightest.
That was obscure. DTCC is the list of CDSs outstanding I reference from time to time. I meant to say that the no one seems to have been willing to write a CDS directly naming hedge funds. It may be that the loans were in a CDO of some kind that included a loan made by the bank to a hedge fund.
Makes sense, if neither CDOs nor hedge funds are regulated.
And if hedges were using $2 to leverage $60, then it wouldn’t take much time at all to completely over-inflate the bubble at 1:30 odds.
I don’t think anyone so far has had the guts to state how vast the greed was, nor the commensurate debts. Don’t mean to be a pessimist, but it’s my hunch there simply isn’t enough to cover the debts.
Which is the untouchable topic?
Am I right?
I admit a bit of concern on that. I’m pretty sure a lot of the CDSs naming big corporations as the reference entity will expire before the companies crash.
We don’t know the volume of the CDSs written on CDOs loaded with trash, so we really don’t know what we are talking about.
I hope it’s not that bad.
Indeed. And that very fact suggests (to me, at least) that it is so big, and so bad, that noone is willing to even report what they dread.
And anyone could buy CDOs and CDSs. It sure makes sense that some ‘financial terrorism’, or at least ‘financial sabotage’ entered the system and could hide easily in a go! Go! GO! world where money was moving along optic fiber at millions by the minute.
Why CDSs have not been declared unilaterally, globally illegal as of Jan 1st suggests that some dark forces still think they run the planet. Those things should be summarily declared illegal. After that, we might have a shot at figuring out the real size of the remaining mess.
I’m pretty sure just about anything that bears interest and regular payments was securitized.
I liked Shitibank as the name of the “bad bank”. h/t to Josh Marshall.
There should probably be a contest to properly(!) name it.
I’m going for the Bush Bank, to honor the president who presidented during the culmination of this disaster.
” Davos has the air of a crash inquiry into an airline that intends to keep on flying. One hero, alone among thousands, suggested that the bankers should simply be jailed until they give the money back. “
http://www.guardian.co.uk/busi…..on-clinton
Please read my alternative bailout proposal:
http://www.unknownliberal.org/blog/?p=216
Why are we not doing something rational for everyone instead of rewarding the people who created the mess?
masaccio,
As I’ve explained to you before, collateral posted on CDS contracts is not tied up, and is freely available for lending. Posted collateral can be rehypothecated. I know you know this, because last time I explained this to you, you went and looked up the definition of “rehypothecate.” The fact that you repeated this claim even though you know it’s not true strongly suggests that you’re simply not arguing in good faith. Why, I have no idea.
Moreover, the DTCC data show that after eliminating offsetting CDS contracts, the net notional outstanding for single-name CDS is only $1.4 trillion, and the net notional outstanding for index CDS is only $1.2 trillion.
Judging by the number of comments, you’ve misled a number of people with this post. Several people now probably believe things about the CDS market that are fundamentally untrue. Is that seriously what you want your contribution to be?