A DEFAULT BY ANY OTHER NAME...

I really want to see what happens to the CDSs out there and just how much of the Greek debt is covered by these things.  But first we have to have a default and according to the ISDA, we don't have one...yet.

This morning, the ISDA ruled that the mere existence of a Collective Action Clause inserted by the Greeks ex post facto in bond indentures governed by Greek law does not constitute a default and neither does unequal treatment for the ECB in any write-down of Greek debt.  Ok so far.  But what happens if certain bond holder refuse to fold and do not join the restructuring even in the face of these clauses?  Ah, that's a very different thing indeed...or at least that was indicated today in the announcement.  Do we know or suspect any more than we did yesterday and if not why is this important?  Well, that's because the Euros, whether by design or by accident, put themselves into a bit of a box.  While all this was going on at the ISDA, the Euros announced that there would be no bail-out on March 9 unless all the private creditors agreed to the debt swap.  With that comment and the comments from the ISDA today, I would think that bondholders holding CDS cover obtained a significant amount of leverage against agreeing to the swap. At some point they are going to get 30% on the face amount and if you were a speculative purchaser such as a hedge or vulture fund, your downside is probably limited.  Sooooo...this could get very interesting over the next few days as the clock is really running.  Let's see who blinks first.

 I watched a bit of Mr. Bernanke today completing his second day of Congressional testimony, this time before the Senate.  Not much to add.  What struck me was that in two days none of our elected officials seemed overly concerned about the absolute flood of liquidity taking place all over the globe.  It's astounding, really.   There isn't a central bank around that isn't just shoveling money out the door and yet it doesn't appear to be a concerted action.  Nor is there any expressed concern about rising inflation or commodity prices.  Time once again to talk to with my Really Smart Friend, Larry, to get to the bottom of this.  Bet he's as baffled as am I.   Later.

A LOSS FOR WORDS

There isn't a whole lot going on either here or over there. The G-20 met over the weekend in Mexico and came up with zilch.  By the by, did you even notice that in February this mob always seems to get together some place where it's nice and warm on taxpayer dollars?  And nothing ever seems to happen?  Might it not be better to meet in, say, Moscow?  Can't go out, bloody filthy.  Nothing to do but stay inside and perhaps crank out a few agreements.  Is that too much to ask?  Don't answer.

One thing we did figure out, however, is that Germany has absolutely no interest in bigger bail out funds, IMF contributions or any such approach that would get the good Burgers back home madder than they already are.  That means that all eyes will be on Super Mario and the ECB later in the week when word will emerge as to how much is going to be made available to the European banks in phase 2 of the Free Money program.  Bet it's a bundle.  Then the focus will shift as to just what the banks are going to do with it.  Betcha that a bunch of it gets hoarded away rather than dangled in front of the credit starved European corporations.  The rest will get arbed in governments with a positive yield--an exercise known as the "carry trade."  In the mean time, the Euro is up (again), Italian yields are down, the Spanish held a couple of excellent auctions and love is in the air.  It must be close to spring and I remain somewhat baffled by it all...

And while all of that is going on we shall find out who is going to play ball with the Greeks and who among those with bonds governed by English law isn't.  More important is the decision regarding the CDSs out there: will whatever occurs be considered a "credit event" by whomsoever decides these things and if it is what will be effect upon the markets.  The last estimate of CDS exposure that I saw was in the range of 3.5 billion Euros; not chopped liver but not all the money in the world either.  Things will probably work out ok but if there is a concentration in one or two institutions...well, it could be fun time.  Perversely, I hope there is.  I know, I'm a rotter.

See you tomorrow.

WOFF, WOFF, II

I've taken a far closer look at the rest of the package and surprise, long on language and short on details!  As a matter of fact I can't really make heads or tails of what this thing is and how it's going to work.

As we have said before, one could bet that the Euros would first cover their banks for reasons oft explained but that what was imperative was the absolute requirement that confidence be restored in Italy or else.  Well, with nods and winks, slight of hand and outright misrepresentation, the banks have been "recapitalized" and yesterday we hopefully punched a whole in that little process but if people are prepared to accept the meal placed before them, that's fine with me.  But what I can't understand is how  anyone could have any confidence in what has been put forward as an Italian stabilization package when one looks and discoveres that the "reform" of the Italian pension system for example, will not be completed for almost 20 years.  Italy has a trillion euros of debt that must be rolled in 18 months and there is no creditable plan as to how this will be accomplished.  After the bank bail-out there is but 250 billion Euros in the bail-out fund with the stated intention to gear it up to 1 trillion.  How?  Well, that's a tale for another day.  Further, should the fund be empowered, much of the resources will be allocated to a "first loss" guarantee to the purchasers of Italian debt (assuming there are some) which after all, is a form of a CDS about which one wonders how receptive the market will be to an instrument of this type after, as we have seen yesterday, a loss of 50% on one's exposure is not considered a "credit event."  There is even talk of making the first loss provision "transferrable"--from what one may ask--and negotiable...should be interesting.  One doesn't see bid/offered spreads in the 15-100 range very often, then again these are some of the brightest guys around.

The strange silence one hears is from the IMF.  As we noted, the highly conflicted Mme. Lagarde now runs that shop but despite that fact (or because of it) one would have expected a more active involvment at this stage.  The leverage is going to have to come from somewhere other than Euroland and the IMF is the obvious place with indirect support from those who have bunches of cash laying about--Russia, China etc.  However, there is a small problem: when it becomes involved, the IMF generally imposes what is known as "conditionality,"  which means a nation--or in this case a group of nations--must present a financial plan with which the IMF must agree before resources are made available.  To be sure, there is much political too-ing and fro-ing in all of this but there has to be some kind of a credible plan and as of right now there is nothing resembling a door leading to a tunnel at the end of which is a light.  It's not going to take too long for the markets to figure this out and it is therefore imperative that some of the blanks begin to be filled in at the G-20.  I get the uncomfortable feeling that there's some Yago in the middle of all of this...you know, "'Tis here but yet confused; knavery plain face is never seen til' used." Somebody is going to catch it in the neck on this one.  I'm going to try to figure out who over the weekend.



Special thanks to Amb. Charles Crawford for the kind words on the blog the other day.  He has a couple of most interesting efforts himself in his own name and in the Daily Telegraph on a regular basis.  Trust me, He knows Europe...and a good deal else.

GOOD CHRISTIAN DISCOURSE...

...which we will all see tomorrow in the annual leading article in the WSJ repeating another journal written in 1620 just before the sailing of the Mayflower. It is a wonderful piece that I used to read to my sons every year. Imagine, sailing across the ocean to God knows where on a leaky bucket not much larger than the one owned by Bernie Madoff for a dream to be free. Every year, I love the Journal for printing that article.

Last week, however, I hated it. My Friday's posting was to be a follow-up on TheSuit's testimony or to be precise, one little nugget of the same. Of course, the buggers at Dow Jones had to get to it before me but I came to the conclusion that I should cover it BECAUSE IT WAS MY IDEA IN THE FIRST PLACE (they print earlier than I do) and it is important.

What everyone overlooked except for the Journal and me was The Suit rather blandly stating that Credit Default Swaps (CDSs) in the case of AIG really didn't matter. As the Journal said, "Hello?" Well if credit default swaps didn't matter in the great scheme of things, what the hell is all the excitement about these awful things called derivatives? With all of this regulatory nonsense going on might we be looking at the wrong tree in the forest.

As I have said repeatedly, a CDS is nothing more than an insurance product written on an existing risk generally or most often expressed (the risk) as a bond, a loan or some form of documented liability of a borrower. Now once the original CDS is written the purchaser can market it for oodles of purposes but cut through all the nonsense and there is still the original writer of the risk; in our case AIG. Again, as I have said a half-dozen times, if all of a sudden there was a bid out there from the biggest pile of money in the world (the Fed) on the CDS-covered asset, the credit worthiness of the AIG structured finance unit is no longer an issue. There would still be hell to pay among secondary holders but hey, nothing that can't be settled among gentlemen. But that did't happen. Originally we all thought that it couldn't happen but The Suit has indicated that that portion of AIG's business was manageable. So, one might ask one's self, "Self, where was the problem?"

Before we start rearranging the entire regulatory landscape it seems to me that it might be a good idea to use AIG as a test case in an attempt to discover where it is that the problems truly lie. If we were to do this I have a suspicion that the trail might lead not to those areas already investigated in nauseating detail--with little to show for it I might add--but back to the undiscovered country such as the core businesses of AIG--the straight-up insurance business-- overseen one might point out not by the Federal reserve but by the Insurance Commissioner of the State of New York and the role played from the git-go in this mess by the State's AG, the odious Mr. Cuomo. Nothing may come of it but would we not have a fuller understanding of what really happened? Ponder this over the Turkey and football this weekend. Let us all give thanks for what we have and also for those brave souls it set forth 400 years ago and made all of this happen.

See you next week.

...AND TO CONTINUE

We talked last week about how it was that everything went so badly wrong and promised to discuss what might be done to prevent such a mess from occurring again. In regard to CDSs, the solution (if there is one) might be fairly simple and one without a good deal of disagreement. What set the dire events in motion was the total lack of knowledge on the part of the participants as to the volume of the market and the exposure of the individual participants, not only in aggregate but to one another. There were intelligent and in some cases accurate guesses to be sure, but real time information was woefully lacking due to the fact that there was no central body through which transactions were cleared; the business was conducted as they say in the trade in an over-the-counter market...companies delt directly with other companies directly on their own books with no one keeping score.

CDSs were considered by some (many?) to be just another derivative--a creation whose value is based on something else. Derivatives have been around for some time starting with simple interest rate swaps--you pay me a steam of money on a fixed rate basis and I pay you a stream...based on the same principal amount...on a floating rate basis and VOILA, we have created a fixed rate obligation out of a floating rate one thereby transforming the underlying debt into one or the other. Cleaver and useful, no? Now there is a chance that on side may get it wrong and pay a floating rate during a period of rapidly rising interest rate but the loss suffered will never be the principal amount; it will only be the difference in the cost of money during the period that the transaction is outstanding which in most cases will be only a small percentage of the nominal amount. Not so with Credit Default Swaps. That, my friends, can be a zero sum game for if the underlying obligor defaults, the loss can be 100% for the poor slob who wrote the contract.

AIG and others wrote A LOT of contracts about which no bod ee knew nuttin'. Think of the different result if all of there transactions would have been through a central clearing house. Three things would have been accomplished:

1. Counterparties would have been revealed
2. Outstanding exposures would have been revealed
3. There would have been a hell of a lot fewer contracts written due to the now-revealed exposure which would have tempered the zeal for dealing with companies that were perceived as becoming overexposed

I suspect there will shortly be a clearinghouse for transactions of this type, as there should be, for there is very little disagreement among regulators as to its need.

As to other forms of derivative transactions, there seems to be apparent agreement among regulators around the world that some additional forms of control are required. However, there is yet to be agreement as to who the regulators are to be and how the regulation is to be accomplished. If the institutions involved are banks, the control is fairly simple: bank regulators have long controlled the businesses in which banks participate through reserve requirements; take this risk and you have a reserve requirement of x; do that, x + y; do THAT, (x + y)2. But if they are not banks like AIG? Ah ha, a subject for another day as well as a discussion on rating agencies.

MY FRIEND MIKE

I have a friend named Mike who I have always considered to be the world's third smartest man. A number of years ago we were in the midst of a lavish party being hosed by a sorvereign debt trader of our acquaintance (he used to work for me). Sovereign debt in those days consisted of old bank loans from the eighties, most of which had been restructured under various agreements and which were trading at various discounts with spreads thru which one could drive a truck. At some point in the evening my friend Mike wandered up to our host who was engaged in explaining the intricacies of the business to a knock-out reporter from Reuters to whom I had introduced him and said: "Let me get this straight. You guys make a great deal of money selling debt that nobody else wants to each other." Our host was aghast, the knock-out retreated in horror and I dissolved in gales of laughter. Mike, to this day, has the ability to reduce the seemingly complex to the mundane. We proceeded to get very, very drunk and left knowing that we had won one for the average man.

At the time of The Great Collapse, credit default swaps (CDSs) totaled in some estimations $40 trillion. They were surrounded by mystery but after all is said, they are insurance policies written by one party to cover the obligations of another to someone who doesn't like the credit but yet owns it. Now if you were to ask my friend Mike about this stuff he would probably say why the hell would you want to get into a business where you are guaranteeing the investment of professional lenders when they are supposed to know the credit to whom they lend? He would also question why one would do this with the same credit again and again and again. Told you Mike was a smart guy. Now insurance is a pretty straightforward business: there is a single asset at risk that has a certain value, such as a house. If you are going to collect on a policy you have to have the insurable risk...i.e. you own the house. You can't go out and buy 100 policies on the same house because in the insurance business the minute a risk is insured a record is created that is available to the public so everybody knows what has occurred. It's impossible to game the system. Not so with CDSs. Anybody could write a policy and you could have a claim even without an insurable interest. Or. to put it another way, you could speculate on both ends. You could also sell the damn things or create your own on the very same credit, and this is precisely what happened. There was a very large market in the trading of CDSs with quoted and recognized spreads that were adjusted as the perception of the underlying credit changed but also changed as a result of the perceived change in the credit of the underwriter. All sorts of risk could be written; senior debt, sub-debt, mezzanine etc. It is a complex business, totally driven by market perception and subject to the brutalities of the market.

I wasn't always such. The business of guaranteeing debt goes back centuries but for our purposes, one can say that it was the municipal bond market that marked the emergence of the idea of credit enhancement. Like all other debt instrument, the cost to a municipal issuer is dependent upon its credit rating supplied by well-known rating agencies. A triple-A rating gets the best deal and the cost rises to every issuer further down the rating scale. But what if a low-rated issuer could somehow enhance its debt rating? Well, that would mean a lower cost of issuance and as long as the cost of that enhancement was lower that the premium which would be paid without it, it was a win-win. An important point: The risk of default with a municipality was practically nil: it never happened because governments HAVE THE POWER TO TAX on various levels. Given this fact, firms were only too happy to substitute their credit for a fee to help out the issuers and the investors were more than happy to trade a lower yield for a better credit risk (in actuality, the yield was always a bit higher for an enhanced deal that for a primary issuer of the same credit standing) and in addition, there are many investors who are unable to invest in any credit below a certain credit rating by charter, so this was a boon to all. It was a nice, safe business that made everyone happy. So what went wrong? Tune in tomorrow and try to think like my friend Mike. It's simple, really.