naked capitalism

We have been less than enthusiastic about the choice of Timothy Geithner to be the next Treasury Secretary. Granted, the idea that we will have someone who is intelligent, knows a thing or two about the markets, and is not from Goldman Sachs makes him a big improvement over the Bush incumbents.

However, competence should be a minimum standard, but the Bush years seem to have lowered expectations for public officials considerably. The commentary about Geithner has been uniformly positive. yet commentators have focused on his experience in a general manner and his personal attributes. Given that he has been actively involved in the central bank’s policy before and during the financial crisis, it would make sense to look at his track record. Yet Geithner has been given a free pass, with some of his noteworthy actions mentioned in the media but not analyzed.

Chris Whalen at Institutional Risk Analytics fills that gap in his current newsletter, “What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup.” For those readers who may not know of him, Whalen is a banking industry expert (he sells a very high end research product) and has extensive contacts in Washington. After Whalen, we will also provide some hesitant criticism of Geithner from Andrew Ross Sorkin at the New York Times, who pens a piece that is guardedly critical.

Whalen also discusses the ugly consequences of a GM bankruptcy.

From Institutional Risk Analytics::

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 traunches 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…..

…. until we rid the markets of CDS, there will be no restoring investor confidence in financial institutions….

1) Start with the $50 trillion or so in extant CDS.

2) Assume that as default rates for all types of collateral rise over 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.

3) Now assume a 25% recovery rate against that portion of all CDS that goes into the money.

4) 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….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….

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….

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…

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.”…

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.

Now from Andrew Ross Sorkin at the New York Times:

President-elect Barack Obama unveiled on Monday an economic team with deep experience handling economic crises. But does the man at the center of this star-studded cast, Timothy F. Geithner, the nominee for Treasury secretary, have what is needed to take the nation in a new financial direction?…

Mr. Geithner is clearly a 47-year-old wonder boy….

But Mr. Geithner’s involvement in several ultimately ill-fated efforts to buttress the American financial system is the very reason some Wall Street C.E.O.’s — a number of whom spoke on the condition of anonymity for fear of piquing the man who regulates them — question whether he’s up to the challenge….

While Henry M. Paulson Jr., the current Treasury secretary, has taken a drubbing for the changeable nature of the government’s efforts to bolster the financial industry — some of which clearly contradicted each other — Mr. Geithner has managed, for the most part, to remain unscathed. He’s been widely praised as a bright, articulate out-of-the box thinker who is a bailout expert, to the extent anyone can truly be an expert at fast-changing emergencies.

Behind the scenes, Mr. Geithner was the point person for weeks of sleep-deprived Bailout Weekends. It was Mr. Geithner, not Mr. Paulson, for example, who put together the original rescue plan for the American International Group.

And, of course, Mr. Geithner also oversaw and regulated an entire industry whose decline has delivered a further blow to an already weakened American economy. Under his watch, some of the biggest institutions that were the responsibility of the New York Fed — Bear Stearns, Lehman Brothers, Merrill Lynch and most recently, Citigroup — faltered. While he was one of the first regulators to smartly articulate the potential for an impending disaster, a number of observers question whether he went far enough to stop the calamity.

Perhaps what has most people on Wall Street stirring is Mr. Geithner’s role in the fall of Lehman. At the time of its bankruptcy, he, along with Mr. Paulson, appeared to be the most vocal in supporting the government’s refusal to bail out the firm, according to people involved in various meetings. With hindsight, many in the financial industry blame a deepening of the global financial crisis on the government’s decision to let Lehman crumble.