Look out below
How might the Law of Unintended Consequences play out with the Fannie/Freddie takeover? Well, it just might be the event that triggers the meltdown certain analysts were already expecting with a nasty variety of derivatives known as credit default swaps.
CDSs are, in essence, an insurance policy you take out on a debt instrument you hold, just in case that debt goes bad. As you might imagine, the sellers of CDSs practically printed money as long as the credit markets stayed juiced up through August of last year and debts weren't going bad in any great numbers. Ever since, the threat has loomed that the sellers might actually have to pay out massive "claims" on those insurance policies.
Today an organization called the International Swaps and Derivatives Association meets to hash out whether the Fannie and Freddie takeover would trigger such "claims" on Fannie and Freddie paper. As Chuck Butler explains…
[T]here's a question as to whether the Gov't's conservatorship constitutes a "CDS event", which would force the settlement of the CDS contracts that are outstanding… Fannie and Freddie have roughly $1.5 Trillion in debt outstanding… But that's chickenfeed compared to the notional amounts of CDS contracts that could be multiples of that $1.5 Trillion!
But wait… there's more.
If the Gov't's conservatorship does constitute a "CDS event" there won't be enough debt to settle the contracts, which will lead to a need for cash… And that could lead to major problems, with the least of them being the holders needing cash, might have to sell other assets to raise the cash needed…
"Other assets?"
Say this does actually play out. Institutions laden with CDSs that are dumping commodity plays and resource stocks for no other reason than they're actually sellable and can generate cash would suddenly move into overdrive. But that probably still wouldn't be anywhere near enough cash to prevent a major deflationary episode, so the Fed suddenly monetizes all these bad debts and triggers a hyperinflation. A malarial economy — chills, then fever.
This is not a prediction, merely a hypothetical. Does it make sense? Is there something I'm missing here?
Sphere: Related Content
Hmmm…. Probably not. I think the printing machine is slated to go into hyperdrive very soon.
Comment on September 9, 2008 @ 5:53 pm
Brings to mind the old adage, nobody makes money in a bear market. Quality stocks get thrown out with the rest in the mad dash for cash, especially in such highly levered markets as we have today and the shorts seem to continually get squeezed by the sharp upside moves common in bear markets.
Comment on September 10, 2008 @ 12:48 am
Just another layer of the onion. These unconvicted felons are finagling their way through this mess as I write this. Of course, they are all in agreement that we must do what is necessary to prevent the feared meltdown.
Somehow, I believe, these slicksters will use this fear as a way of foisting some thing(s) on the unsuspecting (fill in your suspected patsy here).
Only when these criminals are rounded up or hounded down….
Comment on September 10, 2008 @ 1:01 am
A complete takeover like this is PRECISELY what should trigger a CDS event.
Comment on September 10, 2008 @ 1:22 pm
But wait, I think I’m wrong. If the CDS was purchased by Fan and Fred to cover the default of the third party (homebuyer) then this would not necessarily constitute a default on the debt. Even if it did, the only thing that would need to be paid out would be the difference between the par value and the market price of the debt obligation in this case. So I think that is what we were missing - the CDS covers default by a 3rd party, not “default” of the party that bought the contract.
Comment on September 10, 2008 @ 1:39 pm
[...] You have to leverage up those premiums and put yourself at the center of a worldwide nexus of credit default swaps. Which is exactly what AIG [...]
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