I’ve long suspected that no one has the foggiest idea of what the economic exposures of CDS really are (oh yeah, they are hedged? How? Dynamically? Using correlation models based on a few years of data and also happen to be blowing up?).

This market has never had a big shock. We are going to find out how well these hedges work in due course.

The Bank for International Settlements uses a concept of “gross market value” to weight the real exposure. This is roughly 2 per cent of the notional level. For Bear Stearns this would be $270bn, or so.

“There is no real way to gauge the market risk,” said an official

“We don’t know how much is backed by collateral. We don’t know what would happen in a crisis, and if we don’t know, nobody does,” he said.”

WTF mate? They are telling us “actual risk is magnitudes lower” and 2 sentences down “”There is no real way to gauge the market risk,” said an official”

Is it just me or is there an inherent contradiction here? If risk cannot be quantified, where does this 2% come from? Past experience? A “model” perhaps? Like Countrywide with RMBS which central assumption was that houses prices would not go down for more than 6 months in the next 50 years?(!) (Excuse me while I reach the airbag…)

The health insurance metaphor is quite clever, and may well have a lot to do with the Fed’s action, but there are also broader worries.

Remember LTCM. The Fed got a bunch of institutions it for the most part did not regulate (it was mainly securities firms like Goldman, not banks like JPM or Citt that were exposed) ti rescue a hedge fund, which it in now way, shape, or form regulates. And that was back in 1998, when the financial system was less tightly coupled than now.

Remember how in 2003 a small failure in the electrical grid near Cleveland took down much of the east coast? That it the Fed’s world view, that if someone not necessarily very large in the abstract, but sufficiently involved in the vulnerable parts of the system failed (and Bear was a big player in lending to hedge funds and credit default swaps, two worrisome areas), it could take big parts of the financial system down.

Why should this matter? Since 1980, banks have lost market share in credit intermediation to investment banks. Only 15% of non-agricultural lending is via banks. If investment bank balance sheets are damaged, or securitization goes into hyberntation, as now, credit becomes scarce. Look at the stories about banks cutting unused credit card and home equity credit lines, Mortgages are hard to get even for good borrowers. Highly rated corporations are paying high costs on bond issues due to credit default swaps prices being high.

If that sounds bad now, the Fed does not want to take the chance that it would become vastly worse if a Bear or bigger failed.

I’m not saying I agree with the logic; I’m appalled that the Fed doesn’t have a better grasp of the downside. But that’s the scenario they are worried about.

The fact that Rubin was former co-president at Goldman and was on the board when Citi got up to its eyeballs in dubious paper is appalling. Most banks have a lot of lightweights (in terms of business/financial acumen) on their board (deans of colleges are one of my faves). Rubin should have been asking tough questions and evidently chose not to.

Rubin was head of risk arb at Goldman, which meant he speculated on corporate takeovers. He dealt in the equity markets not the debt markets.

JPM also went a long way to defuse the CDS misperceptions during its investor day. I belive Jamie Dimon was going to have his credit guys put out a white paper to explain how the NY Times article vastly misunderstood the true nature of the exposure. Be interesting to see if that report ever sees the light of day.

As for Robert Rubin chiming in with a call to goivernment action, he should be in the cellblock for establishing the failed precedent that laid the foundation for where we are and then the willful neglect at Citi. I belive he was n Arb guy at GS

Assume that Bear Stearns was a health insurance company. It’s customers have paid premiums over the years and expect BSC to pay off on their claims. Many have had surgery. Some have had babies.

Assume also that these customers have borrowed money (for cars, homes, etc) from JPM.

If BSC doesn’t pay their health insurance claims, the customers will have to pay out of their own pockets. And they won’t have money to pay the interest and principal on their loans to JPM.

If all these people stop making payments to JPM, JPM goes belly up.

The govt really doesn’t care about BSC. They care a lot about JPM. Even the slightest threat to JPM is viewed with concern.

Simple solution: the govt has JPM take over BSC. JPM pays off on the health insurance claims (or,at least, says it will). The customers now have the money to py the loans back to JPM.

“This popping of the bubble in real estate has been much more pronounced than anybody would have expected,” Gumbinger said. “If property prices are falling, think how property tax revenues have to fall. There is a troubling connection between the decline in one market, especially one as wide as real estate, and government’s ability to operate.”

What the OFHEO did Wednesday was make a “significant portion” of those tied-up reserves available to Fannie and Freddie to do what they do for a living — which is to buy up loans that meet their criteria, either repackaging them into mortgage-backed bonds or putting them on their own shelf for a while.

The multiplier effect involved works similarly to a bank receiving a large new deposit.

The amount of lending that can be accomplished ends up being significantly greater than the deposit itself.

In this case, OFHEO is freeing $200 billion on Fannie and Freddie’s books, and authorizing the two to push their own mortgage-investment holdings to as high as $2 trillion.