Wednesday, November 18, 2009

The apology of Geithner: AIG

Geithner was pewned like a noob. Yves Smith of naked capitalism wants Geithner lynched for how he handled the AIG situation. This was covered in another entry called "don't send a boy to do a man's job" namely that Geithner, could have negotiated a better deal than paying PAR on CDS.

It gets a bit technical but bear with me.

One first important fact is that in the CDS bucket AIG was holding there was a 4:1 naked to covered ratio. Why is this important? SocGen and reportedly Calyon and DB all held the CDOs. So these guys were taking serious REAL losses on subprime. But for each one taking a loss, there were 4 just SPECULATING, mostly worldwide Hedge Funds through primary dealers IB.

A first real shame, imho, is that these speculating HF clients would have taken NO LOSS on a default of the payments but the premium they paid, the notional was never put in play by these guys. NAKED CDS IS THE FIRST SPECULATING ABSURDITY. G-boy could have in principle said "you and you were speculating, not taking real losses so screw you, we are not paying jack shit, go fuck yourselves". Of course in real-life this means a bunch of law suits and contract breaking and is plain impractical because see below.

But to put things in perspective, guys like Paulson (not Hank, the hedge fund guy) were deified as the “geniuses that saw it coming and pocketed $2B out of it”. Top dogs indeed! I squarely put the blame at the feet of the instruments of mass destruction they used, NAKED CDS on synthetic and straight subprime CDOs to speculate. Run some numbers: if Paulson personally made $2B and assuming he gets 50% of a 20% performance fee that means the fund brought in $20B (at least, if he gets 10% it was 100B the fund brought in), well RIGHT THERE is your CDS mess money. And how do we pay for it? with hunger in the US! I am not even joking or being facetious on this one. The direct result of the massive speculating was an amplification of damage.

Second, I am trying to replay the picture in my head, I am not sure G-boy had much room to maneuver. It is the “fait accompli” theory. He had his back against the wall. Let me try and explain how I see it.

GS and most Investment Banks (IB) were just holding back-to-back agreements.

Case A: One hedge fund was long, the other short. IB has no beef holding 2 canceling swaps, one short one long with 2 HF. I will call this HF-HF

Case B: One hedge fund was short, bought from IB, IB re-insures with AIG, the final trade has a structure that looks like AIG-HF, as opposed to HF-HF.

It is speculated that panic of AUG 07 was triggered by the unwind of a large portfolio of HF-HF. Remember that naked CDS just created 4 times the volume of liquidity that was put in the first place through CDOs on subprime. This to me is a mind-boggling mistake since it created a LIQUIDITY IMPLOSION. Quants started barfing. If the subprime debacle was $250B of real losses, a 4x multiplier meant: on top of $250 of vanishing assets, the HF+IB system had to come up with $1000 (yep, 1 TRILLION) in ACTUAL liquidity over a relatively short period of time. This is assuming 100% of CDOs were covered. Adjust the numbers for the proportion of CDO that were covered (?10%, i am making up) and you still arrive at the pretty scary numbers of $100B of liquidity. This in my mind, is the suspect #1 catalyst for the 07 quant panic. (A liquidity implosion triggered by CDO subprimes and fueled by naked and covered CDS) So a few HF went POOF! and took the market with them, in a generalized LTCM panic moment.

But more importantly, in the second scenario AIG-HF, you see where the system fell down. Here is how the run plays out imho (pure speculation :) . The CDS goes nuclear as the subprime virus spreads, it triggers liquidity needs at the HF level then the IB level. This is where things get complicated. At this point, the liquidity is GONE from the IB and the velocity of the money is nil as the recipients are not putting it back in game. We got a liquidity drain followed by a liquidity desert. So the liquidity stops at the recipients who go cash amid imploding Bear and markets. So first of all any haircut on naked OR on covered would have resulted in a real liquidity loss at the IB level as the CDS horse had left the barn. Anything less than par would have in fact left holes in place AT THE IB level. Of course the real shame to me is that the HF level (or proprietary IB desk) that was speculating all along (naked) got paid in the first place AND triggered the liquidity crunch. The crisis of insolvency was driven and realized by a crisis of liquidity. In retrospect the authorities were right to first treat liquidity problems even in the face of insolvency.

Then the dynamics laid out in the referenced blog take over, namely, AIG is nationalized anyway, so there is no threat of a legal bankruptcy possible anyway, the french and the german, not only are facing real losses but also understand that the FED will NOT hamper the US IBs and just hide behind their counterparts.

A tell tale sign is that 2% cut UBS offers. Think about it, the underlying CDOs where 70-90 down? That tells you UBS was acting as a IB broker and had ALREADY paid par on their contracts.

And why did they pay par in the first place? because unlike their US govt, they had 1/ contractual obligations (IB-HF) that would have resulted in lawsuits bar bankruptcy negociations 2/ They KNEW uncle sam would ultimately FOLD when confronted with the FAIT ACCOMPLI described above.

G-boy was a tool, a pawn, there was NOTHING he could do. The FED has been put in place to prevent runs on the IB system in 1907, that is its charter, what it does. That is what it did. A/ Audit the FED B/ Ban naked CDS. The AIG/CDS payment was a systemic disgrace where no one bears the blame.

The free market, if left to its own devices, creates monsters. It is high time the pendulum swing back from "laissez faire" with some skull cracking force.

2 comments:

Bill Burke said...

I agree that geithner shouldn't be blamed (or asked to resign by these baffoon replication house reps). He nor the Fed, nor Paulson could play poker with the economy considering how bad things were (and still are). You can't take chances or make decisions based on ideology when looking over the abyss. You take the approach with the least risk, even if it looks on the surface to be vastly more expensive.

Fix the problem. Give the Fed, Treasury, and SEC the power and funding to do their jobs. Write the legislation to prevent more Madoffs. The crisis showed that nobody can be trusted to do the right thing, so its time to treat everybody like babies.

Marcf said...

Hey Bill, yeah... but you know in 2000 we had Sarbox hit us like a brick wall. Where is the Sarbox now? you can hear crickets... we were left to our own devices when the dotcom exploded. "Lessons in capitalism etc" "only the strong survive" and other bullshit. But now? With banks..oh no, not the banks. With the banks, the parasite at the top of the capitalist system, the tough rules don't apply, no not them and their bonuses, nope sir. We sure didn't get bailed out in the days and JBoss was born, in part because of it.

I agree with the sentiment that the FED was cornered with AIG, but the legislation that would prevent such abuse again (ban naked CDS) is nowhere to be seen. Moral hazard has become the norm as a result.