Read And Act
Settlement day approaches for derivatives
By Aline van Duyn in New York
Published: October 1 2008 03:00 Last updated: October 1 2008 03:00
The $54,000bn credit derivatives market faces its biggest test this month as billions of dollars worth of contracts on now-defaulted derivatives on Fannie Mae, Freddie Mac, Lehman Brothers and Washington Mutual are settled.
Because of the opacity of this market, it is still not clear how many contracts have to be settled and whether payouts on the defaulted contracts, which could reach billions of dollars, are concentrated with any particular institutions.
According to dealers, insurance companies and investors such as sovereign wealth funds, which are widely believed to have written large amounts of credit protection through credit default swaps on financial institutions, could have to pay out huge amounts.
"There is a lot at stake," said an executive at one big dealer. "This is a crisis time, and if these auctions do not go well, or if the amounts investors and dealers have to pay is seen as not being fair, it could have further negative repercussions on the CDS market."
The "auction season" starts tomorrow, when the International Swaps and Derivatives Association has scheduled an auction for Tembec, a Canadian forest products company. This is followed by Fannie Mae and Freddie Mac auctions on October 6. Then, Lehman is settled on October 10, and Washington Mutual is scheduled for October 23.
Even though it is possible that some participants in the credit derivatives market will have to make large payouts, the flipside is there could also be big winners. For every loss in credit derivatives, there is a gain.
The amount of contracts outstanding that reference Fannie Mae and Freddie Mac alone is estimated to be up to $500bn. The default was triggered under the terms of derivatives contracts by the US government's seizure of the mortgage groups, even though the underlying debt is strong after the explicit government guarantee.
The CDS contract settlement could result in billions of dollars of losses for insurance companies and banks that offered credit insurance in recent months. The recovery value will be set by auction. Usually, the bond that is eligible for the auction that trades at the lowest price - the so-called cheapest-to-deliver - is the one that sets the overall recovery value for the credit derivatives.
In the Lehman case, numerous banks and investors have already made losses due to exposure to Lehman as a counterparty on numerous derivatives trades. The auctions next week are for credit derivatives which have Lehman as a reference entity. There are likely to be fewer contracts outstanding than for Fannie Mae and Freddie Mac because Lehman was not included in many of the benchmark credit derivatives. However, exposure remains unclear, which is one concern that regulators now have about the credit derivatives market.
Lehman's bonds have been trading between 15 and 19 cents on the dollar, meaning investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar, a relatively high pay-out.
The previous biggest default in credit derivatives was for Delphi, the US car parts maker that went bankrupt in 2005 and which had about $25bn of CDS.
Fortunately, we have the Mogambo Guru to provide some needed perspective:
Fed Up With Total Fed Credit
"My voice trembles as I read aloud that now, for the first time ever, the Fed has created over a trillion dollars' worth of new credit, $1,134,942,000,000.00 to be exact, in the banks, which comes to $3,783 for every man, woman and child in America."
by The Mogambo Guru
The national debt, more correctly known as Treasury Gross Public Debt, shot up $141 billion last week! Yikes! Don't multiply $141 billion by 52 weeks because you will plotz at the answer, and we are so freaking doomed that I cannot chug raw tequila fast enough to dull the rising feeling of doom or the rising taste of vomit tinged with blood.
Sure enough, the monetary base exploded to 911.350 from 843.825 in one week! Gaaahhh!
And as bad as this was, nothing could have prepared me for the news that Total Fed Credit jumped by an unbelievable $203.6 billion last week! In one week! $203 billion! In one lousy week!
This unbelievable, unprecedented, staggering $203.6 billion increase in credit is in the Federal Reserve account that, in the old days, used to run $10 billion a month, which was considered excessive, all the way during the huge 11-year inflationary run of money and credit that began in earnest in 1997, which produced all of the bubbles that are now bursting and causing this economic mess.
Now, instead of a white-hot $10 billion a month, now it's 20 times as much, $203 billion! And in one week!
Gaaahhh! We're freaking doomed!
My voice trembles as I read aloud that now, for the first time ever, the Fed has created over a trillion dollars' worth of new credit, $1,134,942,000,000.00 to be exact, in the banks, which comes to $3,783 for every man, woman and child in America.
Hell, the one-week increase in Total Fed Credit alone is $2,030 for that selfsame every man, woman and child in America, assuming that there were no new Americans added to the census since the last paragraph!
And this stupefying rate of expansion is literally off the charts, as in the entire history of TFC, it had grown to only $931.34 billion, reached last week, and now, this week, it has increased $203.6 billion - a 22% increase! In One Freaking Week (OFW)!
We are So Freaking Doomed (SFD) that I reflexively run and hide under the stairs until I can reconnoiter the path to the Mogambo Bunker Of Last Refuge (MBOLR), and if the coast is clear, dash to its musty safety and lock, lock, lock myself in, perhaps then firing off a few rounds to let the neighbors and miscellaneous passersby know that I am scared and I mean business. Maybe then I can relax!
After awhile, as my jaw muscles unclench from the fear, I would be able to explain that this TFC is the source of the fabled "money from thin air" of story and song, which I had hoped would be best remembered by my Mournful Mogambo Ballad (MMB) titled "Fiat Money from Thin Air".
Alas, the tune proved to be less popular than I had hoped ("I actually feel soiled having just listened to it." - Chicago Sun), but which contained the immortal lyrics, "Fiat money from thin air will create real debts from thin air, which will accumulate and get bigger and bigger in a huge inflationary boom caused by all of this new money and credit until it reaches its maximum size, depending on various permutations of tax rates, regulatory zeal and social custom, all of which get looser and looser and weirder and weirder as time goes on, whereupon one day 'something happens' and the whole economy collapses, including the currency, which will cause those flying monkeys from The Wizard of Oz to appear from thin air, and some of them will swoop down and bite chunks out of the heads off of you, your parents and your children, and you will all die screaming unless you own gold, and if you don't own gold in the face of such rampant inflationary corruption and actual carnivorous flying monkeys, then you are stupid, stupid, stupid and you deserve to die! Hahahaha!..."
If you don't have every prep you think you need, get them now.
Good luck to everyone.