naked capitalism

We wrote a couple of days ago that one of the reasons for rescuing AIG was that its failure would have had a devastating impact on EU banks. The insurer had entered into credit default swaps that enabled European banks to evade minimum capital requirements. Thus, an AIG failure would have put a considerable number of banks below required levels, creating another round of panic and in an extreme case, possibly leading to more failures.

Reader John helpfully provided us with the level of the Euro banks’ reliance on AIG, at least as of the end of 2007, per AIG’s annual report:

… Approximately $379 billion (consisting of the corporate loans and prime residential mortgages) of the $527 billion in notional exposure of AIGFP’s super senior credit default swap portfolio as of December 31, 2007 represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation. …

It isn’t clear whether this translates euro for euro into reduced capital requirements (the amount of capital required under Basel II is dependent on credit rating), but $379 billion is a very big number.

Another reader pointed to this section of a on the Fortis recapitalization:

Within the CDO origination portfolio, the high grade assets are anticipated to be written down to 25% and the mezzanine and warehouse positions to 10%. On average 78% of the total CDO origination portfolio is written down.

As he noted:

I did not keep track of where other banks stand on that front, but this looks pretty bold. So I expect Fortis’ auditors to start arguing for similar cuts in their other clients’ CDO portfolios, with the dire consequences that we know in terms of solvency ratio / capital needs / share price… at least for those banks who are not “en cour” with the Treasury Secretary.

CDOs are sufficiently heterogenous that maybe, maybe, some firms still holding large CDO positions may be able to argue for better treatment. But the flip side is that the few trades that have taken place appear to be at pretty distressed prices, and the residential and commercial real estate markets continue to go south, and LBO loan prices (LBO loans were sometimes included in CDOs) are falling, so auditors have every reason to insist on lower valuations if bank have failed to implement them.