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Monday, February 11, 2008 7:38 PM


Credit Default Swap Tsunami Approaches


Blomberg is reporting AIG Falls on Concern Losses May Have Been Understated.

American International Group Inc., the world's largest insurer by assets, fell the most in 20 years in New York trading after its auditor found faulty accounting may have understated losses on some holdings. AIG's auditors found "material weakness" in its accounting for the contracts, and the firm doesn't know what they were worth at the end of 2007, the filing said.

"It raises the question about whether management is in control of what's going on with their derivatives," Edward Ketz, a Pennsylvania State University accounting professor, said in an interview. "The uncertainty as to whether additional losses are coming is as unsettling as anything."

Fitch Ratings may lower the insurer's AA credit rating because AIG's "weakness in internal controls," coupled with "current market conditions, contributes to uncertainty regarding the valuation" of the derivative portfolio, the credit-ratings company said in a statement today.
Depression Levels In Housing

Back on August 9th Chief Risk Officer Robert Lewis said that almost all of its subprime mortgage holdings were safe unless the U.S. housing market crashes to "depression proportions."

By AIG's definition, housing must be at "depression levels". However, we are only in the third inning or so of housing declines. Six more innings are coming. What will AIG's swaps look like then?

It would be interesting to know who is on the other side of AIG's bet. The Wall Street Journal called me today asking my opinion on these swaps. I explained the real fireworks start when there is a major default on swaps. In all likelihood, at least for now, AIG can cover that loss. It will be painful and they may have to raise capital, but for now they can do so.

However, there are $45 trillion of credit default swaps out there. A default on a mere 10% would cause an economic disaster. Unfortunately, it's guaranteed to happen.

Companies like Citigroup (C), AIG (AIG), Merrill Lynch (MER), Lehman (LEH), Morgan Stanley (MS), might think they are hedged. If so they are only fooling themselves. Just what is a guarantee from someone like MBIA (MBI), Ambac (ABK), or Madame Merriweather's Mudhut Malaysia worth? The answer is nothing.

I mentioned dear Mmm. Madame Merriweather to the WSJ today and said that may as well be who is guaranteeing this stuff.

There are countless hedge funds out there, leveraged to the hilt in garbage that has not been marked to market. The same holds true for banks and as we have seen today, insurance companies like AIG.

At some point, some company will declare bankruptcy or a debt downgrade will trigger a claim. That claim will not be paid because the hedge fund or mudhut (whichever comes first) does not have the means to do so. A cascade of defaults will occur up the line on any corporation counting on that claim as part of their hedge.

Consider GM. The market cap of GM is $15 billion or so. There are about $1 trillion in credit default swaps bet on the success or failure of GM. It is virtually impossible for this to be hedged because there is not $1 trillion in GM bonds available as collateral.

The credit swaps on MBIA, Ambac, and the homebuilders trade deep into junk, some priced outright for default. Is there any wonder Moody's, Fitch, and the S&P are reluctant to downgrade MBIA and Ambac? The ratings assigned to Ambac and MBIA are a joke.

AIG Cannot "Reliably Quantify" Losses

The Financial Times has this take on The Debacle at AIG.
AIG produced the revised figures after PwC, its auditors, concluded that there was a “material weakness” in the way the insurer valued its exposure. AIG’s move came after Peer Steinbrück, Germany’s finance minister, warned at the weekend that losses on securities linked to US subprime mortgages could reach $400bn. AIG has written $78bn of credit default swaps on CDOs, which protect the purchaser from a CDO’s failure to pay.

The primary providers of the hedges are bond insurers such as MBIA and Ambac, whose ability to pay claims is causing growing concern in global markets. These have written about $125bn of protection on “senior tranches” of CDOs, according to data from Standard & Poor’s.

AIG told investors in December that it estimated valuation losses on its credit default swaps for October and November at just over $1bn. AIG has scrapped the adjustment because market conditions mean it cannot “reliably quantify” the figure.
Default Swaps Intensify Credit Crunch

Is the loss at AIG really $5 billion or is it $10 billion, or is it more? Don't ask AIG, they don't have any idea. AIG cannot “reliably quantify” the figure. That sure must be a huge confidence booster to investors.

Minyanville's newest professor, Rob Roy touched on this theme in Default Swaps Intensify Credit Crunch. Following are some snips from a lengthy article. Inquiring minds will want to read the entire article.
Over the past several years my firm has highlighted the risks in the sub-prime sector, the lax lending standards, and the housing bubble that peaked in 2005. The residual effects of these have been vast and continue to support our view that the unraveling of the debt issue is not contained.

Housing is clearly in a near-death spiral with inventories rising on months of available supply basis, despite many homeowners de-listing their homes and waiting for a turnaround. Here in Orlando there is 5 years worth of available home lot inventory waiting for developers to fill in the new suburban subdivisions that were developed.

Abnormal events are magnified with financial leverage, and even normal events can become catastrophic with large amounts of leverage. This is clearly seen with the sub-prime and other low quality loans that were packaged into Collateralized Debt Obligations (CDOs) and then sold off to institutional investors thirsty for higher returns.

The dollar has been rallying lately, which is contrary to what you might think, but what if the US actually is the best house in a bad neighborhood? Could the dollar rally against the Euro as the problems at European banks like Union Bank of Switzerland, Societe Generale, Deutsche Bank (DB), Barclay’s (BCS) and Credit Suisse (CS) surface day after day? Every day it seems, a new financing is announced by a major bank (lately by the likes of Citi (C), PNC, and Wachovia (WB) just to name a few) in order to ‘shore up capital’.

Just last night, MBIA placed $1 billion equity financing in order to keep its AAA rating. This comes after a $1 billion subordinated debt issue meant to accomplish the same thing. What comes after you issue debt, and then have to issue equity? Regardless, the bonds trade at CCC levels, so the market, including my firm, isn’t buying it.

Now enter the regulators, like the Insurance Commissioner of New York, Mr. Danalli. To solve this situation, the regulators are asking banks like Citi and a bunch of European banks (which already have their own funding problems) to ‘bail out the municipal insurers’. Supposedly we can’t let them fail because the result would be too large and would finally hit the individual municipal bond investor right between the eyes.

The problem with this potential solution is that the bailors (banks) have the same balance sheet problems as the bailees (insurance companies). The banks have hundreds of billions of dollars of exotic paper that they really don’t know how to price, yet if they let the insurers fail, they will be forced to write down their own positions simultaneously. This becomes one vicious cycle of capital raising in the banking and brokerage industry...

If you think the banks are a mess, try taking a quick look at the balance sheets of companies like Lehman (LEH) and Bear Stearns (BSC). These companies have balance sheets that are literally 40 times their shareholder equity. They also own 3 times their equity in what is known as ‘Level 3 assets’—those that can't be accurately priced, and can’t even be estimated based on a model. Level 3 is ‘mark to management’s best guess’.

Best guess is better than what Citi’s CFO said when asked about its $60 billion of CDOs. On the investor conference call he stated that their positions were ‘marked to a reasonable stab’. I know this may sound as if I am making this up, but sadly, I am not.

Many credit derivative transactions don't simply involve two parties but are often times the risk is passed from one party to the next several times. When an event occurs it causes a careful examination of the complicated legal documents which spell out the specifics of solving a default event.

In a legal case from last year, Bear Stearns loaned $10 million to a development in the Philippines which was backed by a Philippines government agency. In order to protect itself from default, Bear Stearns purchased protection from AON for about $425,000. AON was then short exposure to the Philippines government agency, and so then purchased protection from Societe Generale for $328,000. Offsetting the risk gave AON an easy $97,000, right?

Well the project went bust, the developer did not pay and neither did the Philippines government agency. Bear sued AON for $10 million to reclaim their loss under the Credit Default Swap it had purchased from them and AON paid. AON then went and sued SocGen for $10 million asking for a summary judgment claiming that since the one CDS had been resolved it should automatically create a resolution for the second CDS. After several courts opined on the case, AON lost their case, and lost $10 million. The final court ruling was that the language in CDS1 and CDS2 were not identical and that the risk was not purely offset. So instead of making $97,000 they lost $10,000,000. Seems like documentation is a real counter-party risk.

The big question now is, if you have a derivatives contract, CDS, or CDO with another institution, you may start to wonder if your counter-party is sound, and if it is properly documented.

This is the largest risk we see going forward for the financial markets, when investors do not trust their counterparties, when counterparties suddenly decide to pull your financing due to 'balance sheet constraints' and when financial institutions do not trust each other that 'the other side of the trade will settle'.
Things to keep in mind as the credit default tsunami approaches
  • No one can reliably quantify the amount at risk
  • There is no liquidity in any of the exotic credit markets
  • On some products there is no bid at all
  • Counterparties do not trust each other
  • Balance sheet considerations are causing financing arrangements to be pulled
  • Various CDOs and CDSs as well as counterparty guarantees on those products are essentially worthless
  • A major counterparty failure is all it takes to cause a cascade of defaults
Madame Merriweather's Mudhut Malaysia Inc phoned me minutes ago. I spoke with Mme. Merriweather in person. She was upset by my comments to the Wall Street Journal. She went on to say that her AAA credit rating was still intact, that she could make good on her guarantees, and that she was not in any way affiliated with Madame Merriweather's Mudhut Phillipines. "My mudhut is priceless" she stated.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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