I am troubled that I do the respect of replying to your comment at some length, provide links to earlier work, and you do not extend a similar courtesy by reading, or at least skimming them.

I have repeatedly, long before it was popular, have written of the risks of cascading counterparty defaults in the CDS market, Indeed, I have even said it represented the biggest single risk to the financial system. Contrary to everything I have written, you contend that I have said cascading defaults are “not in the cards”. The risks may by happenstance be distributed so it does not happen, or few enough big players may wind up being impaired that they can be backstopped, but I have NEVER minimized the risk of CDS counterparty failures. Indeed, I have also pointed to the risk of mere CDS operational failures, which were also widely discounted.

To say the ripping up CDS contracts, which is what you advocate, will also cause colossal disruption is a completely different statement.

Thanks for your comments on my CDS post re: “force majeure.” Though I am not at all a Constitutional lawyer or even very conversant in contract law issues, the President may have the authority under something called “International Emergency Economic Powers Act.”

Whether he or who in the case of the States – - where were these underwritten? – - has the jurisdiction I have no idea.

I was not convinced by your arguments that cascading defaults are not in the cards, so to speak. If as in the example you gave Goldman Sachs pays you for a Morgan Stanley default but is not in turn paid for an off-setting contract it bought from a smaller house which was not adequately reserved, there goes Goldman! You may or may not be paid in that case even if the instrument is senior which I am not sure of and the way these instruments were underwritten will probably be litigated until your money is worthless.

I am not in favor of annulling contracts, taking your money or anything of the sort for that matter. Unfortunately trillions have just been taken in the stock market and through poor governance;, that’s the nature of joint venture, limited liability capitalism. My point was that you may not be paid anyway if your underwriter is taken under so it would be best to break the chain before it started. I hope I am wrong actually and that there are not massive cascading defaults but I don’t believe so. Once the chain starts to go, the sooner this is done probably the better.

An Economist

three thoughts.

1. while the mortgage-OAS spread is wide, as merkel pointed out, realized volatility is through the roof, which explains most of spread widening. basically, there is so much uncertainty about the future path of interest rates (inflation -> up, deflation -> down) that the market is requiring a significant yield premium to the risk free rate to assume the negative convexity associated with a pass through (FNM) or participation certificate (FRE).

2. in theory, the GSE's were supposed to help compress agency spreads by ramping up their portfolio activities (where they would arbitrage the price difference between MBS and agency debt). however, it appears that on this front, things are not going according to plan.

the crux of the issue is that agency buyers are not willing to buy longer dated agency debentures in size, despite the nationalization. the reason is that the Treasury's plan involves the winding down of the retained portfolios.

according to the Paulson plan, 2 years from now – when the crisis is over – the retained portfolios are going to be run down to $200B over a 10 year period. the principal buyers of agencies are foreign central banks and money center banks who use agencies as a way to invest surplus liquidity. they need this market to be deep and highly liquid to continue their participation.

if the GSE retained portfolios start shrinking in 2 years, the agency market will shrink and become highly illiquid. no central bank wants to own a 10 yr agency bond that is going to turn into an off the run, illiquid security in 3 years time.

so right now, the agencies are having a lot of difficulty funding farther out the curve. most of their issuance is of the overnight and 3/6/9 month maturity.

this is creating problems for treasury. they would like to run a duration-neutral portfolio, just as the companies did when they were private. however, the agency market is not going to allow them to. so their only options are to shrink the portfolio (uh oh) or to allow the duration gap to widen dramatically.

my understanding is that the plan for now is to go ahead and lever up the balance sheets by funding the $150B of incremental purchases via short-term funding. this is a terrible idea, given the massive current account and budget deficits the US government is running.

the irony is that paulson & lockhart are going to put on the massive carry trade that the administration always falsely accused the GSE's of running.

3. a similar chain of reasoning also applies to the core MBS business. agency MBS have contractual maturities of 30 years. actual durations right now are in the 4-6 year range. if interest rates back up dramatically, those durations could extend to 7-10 years.

the paulson plan goes out of its way to emphasize to the market that the fundamental role of the GSE's in the mortgage market is going to change in 2010 and beyond. it's no secret to anyone who covers the mortgage industry that the goal of treasury is to move the US to the covered bond model used in europe.

i'm not going to opine here on whether or not this is a good or bad idea in the abstract. however, if i'm a mortgage buyer, why on earth do i want to buy an agency MBS yielding 5.5 – 6% if there's a chance that in 5 years liquidity in the agency MBS market is drying up because no new MBS or PC's are being issued?

i need to be paid extraordinary rates of return in order to be compensated for the illiquidity that i know is coming in a few years time.

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the sad thing is that i'm not sure treasury understands any of these things. philip swagel, one of the intellectual architects of the GSE nationalization stood up at an IMF panel yesterday and proclaimed that the GSE nationalization was a resounding success because the "conforming mortgage market is working fine".

i suppose that, taken in isolation, that statement is factually correct. of course:

- mortgage rates are now higher than they were relative to swap spreads

- a significant number of community banks (and farmer mac) who held GSE preferreds have been wiped out.

- the GSE action triggered a run on lehman. this ended up taking down AIG, WaMu and Wachovia (all the bank executives have told the street that the deposit runs started on Sep 15, the day Treasury let Lehman fail)

- the market for bank preferred stock and hybrid debt is shut permanently

- the equity capital markets are closed to most financial institutions because most investors have concluded that this group of regulators (treasury, fed & FDIC) are bad partners.

- the icelandic banks have all been nationalized and the country is on the brink of failure.

- the high yield and investment grade bond markets have COLLAPSED.

- working capital is being cut off to corporates around the world.

- the global equity markets are in the midst of a historic crash.

some success.

the treasury completely mis-diagnosed the scale, scope and extent of the de-leveraging that was going to take place. it also had absolutely no idea what it would unleash on the global economy when it decided to play investment banker and start re-organizing the US financial system.

There are also practical reasons why the move you suggest would cause simply colossal dislocations. To wit: some users bought CDS to hedge bonds or exposures they have. If you take away the guaranteee, they have to mark down the position. That swap used as a hedge in turn was in many cases hedged by the protection writer with a party that was simply punting, so you cannot simply preserve the CDS related to hedges of the underlying. The product is too enmeshed with the entire financial system to be able to isolate hedgers.

Similarly, AIG wrote CDS that enabled many Europen banks to evade statutory capital requirements. Void those swaps and the banks are even more undercapitalized (there are reports that the ECB applied considerable pressure to Washington to make sure they bailed out AIG). Many structured products relied on CDS for their credit enhancement. Take that away, and the structured credits are worth considerably less, distributing losses over the financial system (particularly banks, who are substantial holders of structured credit paper).

We are well aware of counterparty risk and were writing about the risks posed by CDS well before they were mainstream. See this selection of many examples “Is Systemic Risk Underestimated” (and note the day, May 2007, before the credit contraction began), “Fitch Points to Credit Derivatives as Possible Accelerant in Credit Downturn” (July 2007), “Are Credit Default Swaps Next?” (August 2007) and “Counterparty Risk Problems With Credit Default Swaps?” (November 2008).

As for the Federal government voiding these contracts, it has no standing. CDS, as contracts, are governed by state law (even if they were deemed to be insurance contracts, they’d still be governed by state law). The Federal government has no basis for interfering in state law matters. A move along the lines you suggest raises serious Constitutional issues and would be challenged, particularly given the number of deep pockets who would be adversely affected.

Prior to the Hankilization of FNM/FRE, their MBS traded at spread premium to GNMA.

You can view all these MBS as amortizing callable/extendible Treasuries.

The spread just reflects the uncertainty as to the timing of return of principal (and total interest) not uncertainty as to return of principal.

I think you are misunderestimating (to coin a phrase) the value of semantics here. Assurances are not guarantees. Given the certain insolvency of FNE/FRE without government support, any withdrawal of such support, or more likely a reduction of such support by requiring haircuts of all stakeholders would send all GSE debt quickly below par. I believe the spread between treasuries and GSE debt is a quite rational discounting of such a possibility.