What Obama Needs to Know about Tim Geithner, the AIG Fiasco and Citigroup
On Friday, the FDIC closed and facilitated the sale of two CA savings banks, Downey Savings and Loan, the bank unit of Downey Financial Corp (NYSE:DSL) and PFF Bank and Trust, Pomona, CA. All deposit accounts and all loans of both banks have been transferred to U.S. Bank, NA, lead bank unit of US Bancorp (NYSE:USB). All former Downey and PFF Bank branches reopen for business today as branches of U.S. Bank.
Earlier this year we wrote positively about Downey and the funding advantages it had over larger thrifts such as Washington Mutual due to the solid deposit base and strong capital. Indeed, as of Q3 2008, the bank's Tier One leverage ratio was over 7.5%, more than two points over the minimum, and its charge offs had actually fallen compared with the gruesome 400 basis points of default reported in the previous period.
But since the September resolution of WaMu and Wachovia, the FDIC, it seems, is not willing to wait to resolve institutions, even banks that are apparently solvent and not below any of the traditional regulatory triggers for closure. The visible public metrics indicating soundness did not dissuade the Office of Thrift Supervision and FDIC from seizing both banks and selling them to USB.
The purchase of Downey and PFF is good news for the depositors and borrowers, who will all be offered the FDIC's prepackaged IndyMac mortgage modification program as a condition of the USB acquisition. Bad news for the investors and creditors, who now see their already impaired investments wiped out.
The resolution of Downey illustrates both the best and the worst aspects of the government's remediation efforts. On the one hand, we have argued that the government should be pushing bad banks into the arms of stronger banks to improve the overall condition of the system. The good people at the FDIC do that very well - when politics does not intervene.
In the case of Downey and PFF, it appears that the OTS and FDIC projected forward from the current above-peer loss rates and concluded that a prompt resolution was required. Reasonable people can argue whether this is the right call. But when we see the equity and debt holders of DSL, Washington Mutual or Lehman Brothers taking a total loss, we have to ask a basic question: why is it that the debt holders of Bear Stearns and AIG (NYSE:AIG) are granted salvation by the Federal Reserve Board and the US Treasury, but other investors are not?
If the rule of driving money to the strong banks' (see "View from the Top: A Prime Solution to the US Banking Crisis") safety and soundness is to be effective, it must be applied to all. And now you know why we have questions about the nomination of Tim Geithner to be the next Treasury Secretary.
If you look at how the Fed and Treasury have handled the bailouts of Bear Stearns and AIG, a reasonable conclusion might be that the Paulson/Geithner model of political economy is rule by plutocrat. Facilitate a Fed bailout of the speculative elements of the financial world and their sponsors among the larger derivatives dealer banks, but leave the real economy to deal with the crisis via bankruptcy and liquidation. Thus Lehman, WaMu, Wachovia and Downey shareholders and creditors get the axe, but the bondholders and institutional counterparties of Bear and AIG do not.
Few observers outside Wall Street understand that the hundreds of billions of dollars pumped into AIG by the Fed of NY and Treasury, funds used to keep the creditors from a default, has been used to fund the payout at face value of credit default swap contracts or "CDS," insurance written by AIG against senior tranches of collateralized debt obligations or "CDOs." The Paulson/Geithner model for dealing with troubled financial institutions such as AIG with net unfunded obligations to pay CDS contracts seems to be to simply provide the needed liquidity and hope for the best. Fed and AIG officials have even been attempting to purchase the CDOs insured by AIG in an attempt to tear up the CDS contracts. But these efforts only focus on a small part of AIG's CDS book.
The Paulson/Geithner bailout model as manifest by the AIG situation is untenable and illustrates why President-elect Obama badly needs a new face at Treasury. A face with real financial credentials, somebody like Fannie Mae CEO Herb Allison. A banker with real world transactional experience, somebody who will know precisely how to deal with the last bubble that needs to be lanced - CDS.
Last Thursday, we gave a presentation to the New York Chapter of the Risk Management Association regarding the US banking sector and the long-term issues facing same. You can read a copy of the slides by clicking here.
As part of the presentation (Page 17-21), IRA co-founder Chris Whalen argued the case made by a reader of The IRA a week before (see "New Hope for Financial Economics: Interview with Bill Janeway,") that until we rid the markets of CDS, there will be no restoring investor confidence in financial institutions. Here is how we presented the situation to about 200 finance and risk professionals in the auditorium of JPM last week. Of note, nobody in the audience argued.
- Start with the $50 trillion or so in extant CDS.
- Assume that as default rates for all types of collateral rise over the next 24-36 months, 40% of the $50 trillion in CDS goes into the money. That is $20 trillion gross notional of CDS which must be funded.
- Now assume a 25% recovery rate against that portion of all CDS that goes into the money.
- That leaves you with a $15 trillion net amount that must be paid by providers of protection in CDS. And remember, a 40% in the money assumption for CDS is VERY conservative. The rise in loss rates for all type of collateral over the next 24 months could easily make the portion of CDS in the money grow to more like 60-70%. That is $40 plus trillion in notional payments vs. a recovery rate in single digits.
Q: Does anybody really believe that the global central banks and the politicians that stand behind them are going to provide the liquidity to fund $15 trillion or more in CDS payouts? 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.
Our answer to this cowardly view is that AIG needs to be put into bankruptcy. As we wrote on TheBigPicture over the weekend, we'll take our cue from NY State Insurance Commissioner Eric Dinalo and stipulate that we pay true hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches and pitchforks catch up to them.
President-elect Obama and the American people have a choice: embrace financial sanity and safety and soundness by deflating the last, biggest speculative bubble using the time-tested mechanism of insolvency. Or we can muddle along for the next decade or more, using the Paulson/Geithner model of financial rescue for the AIG CDS Ponzi scheme and embrace the Japanese model of economic stagnation.
And, yes, we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into a quick and final extinction. Remember, when AIG goes bankrupt the insurance units are taken over by NY, WI and put into statutory receiverships. Only the rancid CDS positions and financial engineering unit of AIG end up in bankruptcy. And fortunately we have a fine example of just how to do it in the bankruptcy of Lehman Brothers.
Our friends at Katten Muchin Rosenman in Chicago wrote last week in their excellent Client Advisory:
On November 13, 2008, Lehman Brothers Holdings Inc. and its U.S. affiliates in bankruptcy, including Lehman Brothers Special Financing and Lehman Brothers Commercial Paper (collectively, "Lehman") filed a motion asking that certain expedited procedures be put in place to allow Lehman to assume, assign or terminate the thousands of executory derivative contracts to which they are a party. If Lehman's motion is granted, counterparties to transactions that have not been terminated will have very little time to react and will likely find themselves with new counterparties and no further recourse to Lehman because, by assigning contracts to third parties, Lehman will effectively receive, by normal operation of the Bankruptcy Code, a novation.
The bankruptcy court process also allows for parties to terminate or "rip up" CDS contracts, something that has also been fully enabled by the DTCC. The bankruptcy can dispose and the DTCC will confirm.
BTW, while you folks in the Big Media churned out hundreds of thousands of words last week waxing euphoric about the prospect for enhanced back office clearing of CDS contracts, the real issue is the festering credit situation in the front office. Truth is that the DTCC and the other dealers, working at the behest of Mr. Geithner, Gerry Corrigan and many others, have largely fixed the operational issues dogging the CDS markets. The danger of CDS is not a systemic blowup - though that will come soon enough. It is the normal operation of the now electronically enabled CDS market wherein lies the threat to the entire global financial system, this via the huge drain in liquidity illustrated above as CDS contracts are triggered by default events.
The only way to deal with this ridiculous Ponzi scheme is bankruptcy. The way to start that healing process, in our view, is by the Fed emulating the FDIC's treatment of DSL, withdrawing financial support for AIG and pushing the company into the arms of the bankruptcy court. The eager buyers for the AIG insurance units, cleansed of liability via a receivership, will stretch around the block.
By embracing Geithner, President-elect Barack Obama is endorsing the ill-advised scheme to support AIG directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. News reports have already documented the ties between GS and AIG, and the backroom machinations by Paulson to get the deal done. This scheme to stay AIG's resolution cannot possibly work and when it does collapse, Barack Obama and his administration will wear the blame due through their endorsement of Tim Geithner.
The bailout of AIG represents the last desperate rearguard action by the CDS dealers and the happy squirrels at ISDA, the keepers of the flame of Wall Street financial engineering. Hopefully somebody will pull President-elect Obama aside and give him the facts on this mess before reality bites us all in the collective arse with, say, a bankruptcy filing by GM (NYSE:GM).
You see, there are trillions of dollars in outstanding CDS contracts for the Big Three automakers, their suppliers and financing vehicles. A filing by GM is not only going to put the real economy into cardiac arrest but will also start a chain reaction meltdown in the CDS markets as other automakers, vendors and finance units like GMAC are also sucked into the quicksand of bankruptcy. You knew when the vendor insurers pulled back from GM a few weeks ago that the jig was up.
And many of these CDS contracts were written two, three and four years ago, at annual spreads and upfront fees far smaller than the 90 plus percent payouts that will likely be required upon a GM default. That's the dirty little secret we peripherally discussed in our interview last week with Bill Janeway, namely that most of these CDS contracts were never priced correctly to reflect the true probability of default. In a true insurance market with capital and reserve requirements, the spreads on CDS would be multiples of those demanded today for such highly correlated risks. Or to put it in fair value accounting terms, pricing CDS vs. the current yield on the underlying basis is a fool's game. Truth is not beauty, price is not value.
If you assume a recovery value of, say, 20% against all of the CDS tied to the auto industry, directly and indirectly, that is a really big number. The spreads on GM today suggest recovery rates in single digits, making the potential cash payout on the CDS even larger.
As Bloomberg News reported in August:
A default by one of the automakers would trigger writedowns and losses in the $1.2 trillion market for collateralized debt obligations that pool derivatives linked to corporate debt… Credit-default swaps on GM and Ford were included in more than 80 percent of CDOs created before they lost their investment-grade debt rankings in 2005, according to data compiled by Standard & Poor's.
At some point, Washington is going to be forced to accept that bankruptcy and liquidation, the harsh medicine used with other financial insolvencies, are the best ways to deal with the last, greatest bubble, namely the CDS market. When the end comes, it will affect some of the largest financial institutions in the world, chief among them Citigroup (NYSE:C), JPMorganChase (NYSE:JPM), GS and MS, as well as some large Euroland banks.
The impending blowback from a CDS unwind at less than face amount is one of the reasons that the financial markets have been pummeling the equity values of the larger banks last week. Any bank with a large derivatives trading book is likely to be mortally wounded as the CDS markets finally collapse. We don't see problems with interest rate or currency contracts, by the way, only the great CDS Ponzi scheme is at issue - hopefully, if authorities around the world act with purpose on rendering extinct CDS contracts as they exist today. Call it a Christmas present to the entire world.
Indeed, as this issue of The IRA goes to press, news reports indicate that C is in talks with the Treasury for further financial support under the TARP, including a "bad bank" option to offload assets. A bad bank approach may be a good model for applying the principle of receivership to the too-big-to-fail mega institutions, but the cost is government control of these banks.
Q: Does a "bad bank" bailout for C by Treasury and FDIC qualify as a default under the ISDA protocols!?
We've been predicting that Treasury will eventually be in charge of C. On the day the government formally takes control, we say that Treasury should hire FDIC to start selling branches and assets. Thus does the liquidation continue and we get closer to the bottom of the great unwind. Stay tuned.
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This article has 54 comments:
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SW Richmond
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388 Comments
Nov 26 07:22 AM-
phil from Edmond
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8 Comments
Nov 26 08:03 AM-
Alan von Altendorf
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353 Comments
My Website
Nov 26 08:08 AM-
john s. gordon
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706 Comments
Nov 26 08:13 AM> jack
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delbmarcs
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4 Comments
Nov 26 08:41 AM-
xsuddensam
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242 Comments
Nov 26 08:48 AMCommon sense tells us that we are paying for a very expensive "Hail Mary" pass to save the reputations of the incompetent political hacks as well as the pocketbooks of the Wall Street crooks that robbed us in the first place.
It's obvious this will not work and they are just buying time at our expense. Unfortunately, where there is so much money involved, there will be more fraud and there will be those who will handsomely profit from our misfortune
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delbmarcs
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4 Comments
Nov 26 08:55 AM-
User 307291
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1 Comment
Nov 26 08:57 AMFor instance in the Lehman closeout, $400B of their debt resulted in $6B (give or take) in actual CDS settlement. Assuming 10-15% of counterparties insured by AIG default over the next 18 months, the gloomiest of nuclear winter scenarios, what is the taxpayers' hit?
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delbmarcs
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4 Comments
Nov 26 08:59 AMOn Nov 26 08:48 AM xsuddensam wrote:
> The absurdity of the bailouts is that the very people who are directly
> or indirectly responsible for the CDS Ponzi scheme, as well as those
> politicians entrusted to be our watchdogs, are the ones trying to
> solve the crisis.
>
> Common sense tells us that we are paying for a very expensive "Hail
> Mary" pass to save the reputations of the incompetent political hacks
> as well as the pocketbooks of the Wall Street crooks that robbed
> us in the first place.
>
> It's obvious this will not work and they are just buying time at
> our expense. Unfortunately, where there is so much money involved,
> there will be more fraud and there will be those who will handsomely
> profit from our misfortune
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Steve Pluvia
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89 Comments
My Website
Nov 26 10:04 AMAre you *seriously* suggesting the U.S. let AIG blow-up?
So let me see if I get your point...
Let AIG fail; All foreign held debt insured by AIG blows up...
-- US treasury and corporate debt immediately has zero credibility;
-- US corporations and have zero borrowing power for short term trade and expansion.
-- Trade grinds to a halt as foreign partners no longer honor purchase orders from US corporations.
-- Run on all banks;
-- The dollar gets crushed; and,
-- The US have very little ability to jump start the US economy with spending
Oy freakin vey. Your idea is ridiculous. Clearly you don't understand the implications of what you propose.
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mc2406
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20 Comments
Nov 26 10:27 AMWhat really scares me is this-- it's more likely than not that no one in our government (Bush's or Obama's, or our Congress) will take the time to really understand what is going on, and thinks that throwing huge amounts of money here and there (ransom) to the perpetrators of the problems will somehow end the crisis.
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billddrummer
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536 Comments
Nov 26 11:27 AMThanks.
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spanish moss
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7 Comments
Nov 26 11:29 AMSubprime mortgages were not the problem they were simply the weakest assets in the chain and were the first to be stressed when the party got long in the tooth.
Now the real issue, the AltA mortgages, generally big principal balances to people with good credit buying on speculation that the property value would rise rapidly, or that if it did not they could simply sell and get out from under the big mortgage before the option arm (PIK a Pay) went up to the fully amortized amount. The number and balance of the Alt A vs. sub prime is staggering.
It was all good... now it's all bad... and the idiots who perpetuated the mess, the bond daddys and rating agencies... well, they have been stocking those million dollar bonuses away for years... wonder what they invested in? Hedge funds I'll bet... and a house in the Hamptons or Santa Fe, or Montana...
At the end of the day, CDSs did not protect anything, they simply moved the risk down the road... now we are at the end of that road.
would risehave shown stress... now the stress has moved into the larger
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Cactusbrush
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1 Comment
Nov 26 12:05 PMI don't quite understand this bit, perhaps you could expand on how this actually works. I get that a big part of the problem was people buying insurance on the Titanic from people on the Titanic. But are you saying that most CDS were not insurance at all, but actually bets with bookies on whether the Titanic would hit an iceberg or not? Does that make them like the mother of all naked shorts?
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Indexor
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86 Comments
Nov 26 12:07 PM-
contraxism
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14 Comments
Nov 26 12:10 PMOn Nov 26 10:04 AM Steve Pluvia wrote:
> You, lost me early in this overly-long soap-box stint.
>
> Are you *seriously* suggesting the U.S. let AIG blow-up?
>
> So let me see if I get your point...
>
> Let AIG fail; All foreign held debt insured by AIG blows up...
>
> -- US treasury and corporate debt immediately has zero credibility;
>
> -- US corporations and have zero borrowing power for short term trade
> and expansion.
> -- Trade grinds to a halt as foreign partners no longer honor purchase
> orders from US corporations.
> -- Run on all banks;
> -- The dollar gets crushed; and,
> -- The US have very little ability to jump start the US economy with
> spending
>
> Oy freakin vey. Your idea is ridiculous. Clearly you don't understand
> the implications of what you propose.
>
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iThinkBig
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1053 Comments
My Website
Nov 26 12:21 PMOn Nov 26 08:55 AM delbmarcs wrote:
> Is there another side to this? Are the current Federal policy choices
> meant to stabilize the system enough to avoid paying off the CDO
> or CDS or whatever they are because there won't be an underlying
> default? Is that behind the Federal strategy? What you are saying
> seems too simple and obvious - "let the Ponzi schemers eat it" -
> but there must be another side to the story. I suspect you are right,
> but want more info so I can understand the choices. Thanks.
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iThinkBig
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1053 Comments
My Website
Nov 26 12:27 PMOn Nov 26 08:57 AM User 307291 wrote:
> Does anyone have an estimate of the government's exposure to CDS
> as a result of AIG's book?
>
> For instance in the Lehman closeout, $400B of their debt resulted
> in $6B (give or take) in actual CDS settlement. Assuming 10-15% of
> counterparties insured by AIG default over the next 18 months, the
> gloomiest of nuclear winter scenarios, what is the taxpayers' hit?
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iThinkBig
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1053 Comments
My Website
Nov 26 12:28 PM-
contraxism
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14 Comments
Nov 26 12:45 PM-
Kinabalu
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149 Comments
Nov 26 12:49 PMYou assume 40% will go into the money and asert this is conservative. I think this is a ridiculously high assumption but at least your math is correct ($50 trillion times 40% = $20 trillion).
You assume a 25% recovery rate on those. This is the only reasonable assumption you use, however 25% of the ridiculously high $20 trillion = $5 trillion not $15 trillion.
The fact that so many readers call this an excellent article without questioning either the assumptions or the math is somewhat disconcerting.
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BerkeleyBob
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116 Comments
Nov 26 12:50 PM-
contraxism
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14 Comments
Nov 26 01:16 PMOn Nov 26 12:50 PM BerkeleyBob wrote:
> Complex issues here, some of the comments are informative, some not.
> Two central points emerge: 1) The damage to US reputation in the
> world financial market is incalculable and grave; 2) AIG appears
> to have been at the fulcrum of making book on leveraged CDO's and
> credit default swaps which were purchased by entities having no
> insurable or legitimate hedge interest in the underlying assets.
> It was not insurance, not regulated, and required apparently no reserve.
> Pure profit for AIG until the Ponzi scheme unraveled. Hank Greenberg
> is as unrepentant as Dennis Kowzlowski or any of the Enron gang.
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Steve Pluvia
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89 Comments
My Website
Nov 26 01:36 PM"Why fund a leveraged wager of CDSs with taxpayers money?"
I answered why we cannot let AIG fail; if we let them fail this happens:
-- All foreign held debt insured by AIG blows up...
-- US treasury and corporate debt immediately has zero credibility;
-- US corporations and have zero borrowing power for short term trade and expansion.
-- Trade grinds to a halt as foreign partners no longer honor purchase orders from US corporations.
-- Run on all banks;
-- The dollar gets crushed; and,
-- The US has very little ability to jump start the US economy with spending
Most do not understand Lehman, Merrill et al packaged ANYTHING with a revenue stream almost ANYWHERE IN THE WORLD into an asset back security, then created synthetic "bonds" when they found it easier than rounding up assets with revenue.
Many of these were insured by AIG. If AIG fails within a week we have a worldwide meltdown. The idea of letting AIG fails demonstrates the author of this article has no idea what he's talking about or is supremely ignorant.
A simpler example is this: Imagine New Orleans after Katrina -- except we let every insurance company out of their obligation to pay policy holders to rebuilding homes/properties. Not only would New Orleans no longer be a city, the lack of confidence in all insurance would go down the toilet.
AIG is a big bag of sh*t, no doubt about it. But letting AIG fail instantly makes commercial paper world wide into toilet paper.
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MichaelSchmichael
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20 Comments
Nov 26 01:44 PMI think the point of the article goes more to the implications of the policy decisions being made and the potential motivations behind those decisions, not whether the specific numbers cited end up being correct or even reasonable. It would be short sighted to dismiss the article out of hand based on an unfortunate and presumably very embarassing arithmetical error.
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xsuddensam
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242 Comments
Nov 26 02:07 PM-
waaaja
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3 Comments
Nov 26 02:39 PMOn Nov 26 07:22 AM SWRichmond wrote:
> Well written and very very informative. You stopped short of suggesting
> that the financial engineers want to hang on to the CDS model as
> long as Treasury is willing to loot the taxpayers to pay for it.
> I'd love to have a look at JPM's CDS book.