October the 1st is too late?

That’s when credit default swaps (CDSs) with a notional value somewhere between $500 billion and $1.4 trillion will have to be settled as a result of the (re)nationalization of Freddie Mac and Fannie Mae, which has been deemed to constitute a default event on their bonds. Paradoxically though because the government guarantee of the bonds is now explicit, they are actually safer than before which means that the net payments required in settlement will be very small, and sometimes go to the party who offered protection against default. Don’t worry too much if none of this makes sense, the main point doesn’t depend on it, but you can read a bit more from The Economist.

As The Economist notes, most participants are expecting all this to go smoothly. But one thing about the longrunning credit squeeze is that unexpected (bad) things tend to happen. So what could go wrong?

It would probably take several things happening at once to bring about a lockup of the settlement of the auction – I’ll add some hints in parentheses)
(1) A major participant in the market runs into serious difficulty close to auction day with the result that its counterparties demand immediate cash or physical settlement, but are slow to pay themselves (Lehman)
(2) A second counterparty unexpectedly turns out to have severe difficulties making it impossible to net out offsetting liabiities (??)
(3) The authorities are distracted by a large-scale failure in the mortgage sector, making it difficult to organise a rescue (WaMu)
(4) There’s a sudden rush out of Treasury bonds, constraining the government from issuing unlimited credit (China)

I don’t know what would happen if this chain of events took place. My guess is that there would be some sort of imposed settlement that would solve the immediate problem but would lead to a rapid loss of confidence in the whole CDS market as we have already seen with collateralized deposit obligations (CDOs) and many other marvels of recent financial innovation. Since the CDS market involves notional claims of $60 trillion and gross obligations of around $2 trillion, that could be quite unpleasant.

Of course, the par bet is still that things go smoothly. Even in a period of crisis like the present, predictions of disaster rarely come true. It’s the unpredicted disasters you have to worry about.

17 thoughts on “October the 1st is too late?

  1. Well the Fed’s bluff has been called and the bazooka drawn-
    We may have Pistol Pete Costello to thank for our better balanced budget situation(albeit that was no doubt facilitated by a combination of taxation by stealth and Reserve money creation), so we might not be as freaking doomed as some believe they are-
    However, sometime, somehow, somebody will have to pay for this total failure of oversight of money supply globally and the clock is ticking on that. Beware the ides of October historically.

  2. someone will need to pay: I volunteer pensioners, unemployed, starving and other superflouous elements of the world population.

  3. Fannie and Freddie stockholders lost a lot of money, but bondholders won’t lose very much. If there was ever a serious risk that Treasury wouldn’t be able to back them up you’d think the yields on Fannie and Freddie should surely have been dropping, when in fact they were rising over the last twelve months and not rising that much different from the yeilds on Ginnie Mae bonds, which are legally backed by the full faith and credit of the government. Basically everybody knew the bailout was going to happen, a fact that willed it into existence. The financial markets are well planned and bondholders know that the government will look after its own.

  4. “I volunteer pensioners, unemployed, starving and other superflouous elements of the world population.”
    Those tenured, indexed, central bank generals can always count on the infantry. It’s just a matter of how many shock troops they can muster for the cause.

  5. #3, I don’t think this will solve the problem. But to pay those who created the problem a disability pension for life might work. These disabling financial innovators produced only (real and integer) numbers in electronic data systems. Pulling the plug and all is gone, including their ‘jobs’.

    One difficulty with the pulling the plug solution, I admit, is that the innovators cleverly did not design a new data recording system which would allow the quick sorting of $(private) and $(government) and hence a selective pulling of the plug. Instead they continued to use the financial accounting framework which assumes that all transactions are ‘in money’. A $ sign looks like a $ sign. Clever, isn’t it.

    In support of what I say, I refer to the indication of the ‘valuation problem’ in JQ’s post(between $500 billion and $1.4 trillion – nobody really knows how big the wrongly classified numbers are), #3’s talk about ‘money supply’.

  6. #4 It seems to me sensible to distingish between the (failed) attempt to privately ensure lending for a purpose (housing) that is at least related to human welfare and mere two-up games.

  7. think Obama’s not fighting back hard enough against all the smears and lies? maybe its because someone told him about the budgetary state of the government he’s going to inherit, and he’s decided he doesn’t want the job.

  8. Perhaps Obama has worked out he and his mob are not really up to the job gerard-http://www.washingtonpost.com/wp-dyn/content/article/2008/09/11/AR2008091102841.html

  9. If the financial markets go really pear shaped there is always the potential war to be waged across Pakistan, Afghanistan, Iran and Iraq to distract the USA population. A lot of unemployed people could be moved to the middle east by the McCain/Palin team or Bush if he moves fast.

    Obama really does start to look as if he is hope of the world in that scenario.

  10. Please don’t publish the October date. I can see Kevin747, heavily retinued of course, using it as an excuse for an o/seas junket. Our gallivanting PM would jump at the chance to log those frequent flier points.

  11. Before our last Federal election I consistenly said that it was the “Poison Chalice” election. Whover won it would be sorry. Prediction: Rudd will be sorry fairly soon. He’s on a hiding to nothing. Things are about to go seriously pear shaped.

    The above goes in spades (if one can have poison chalices in spades) for the US election. This one is the biggest Poison Chalice of all time. Not only the leaders but the world’s population (sadly) will drink the bitterness to the lees.

    I am of the philosophic school that thinks history is not made by a few “great men” or “great women” for that matter. History is made by the combined action of all phenomena; those of quantifiable mass-energy and the predictable behaviour (en masse) of the conscious human actors. History will follow exactly the same path now no matter whether Mccain or Obama is elected.

  12. Pr Q says:

    Of course, the par bet is still that things go smoothly. Even in a period of crisis like the present, predictions of disaster rarely come true. It’s the unpredicted disasters you have to worry about.

    Good to see Pr Q cover his intellectual flank with the obligatory “sky may not fall this time around, but just you wait!” The financial markets have both the worlds biggest bank cartel (the FED) and the worlds largest company (US GOVT) to bail them out.

    THats some heavy cutters to take care of the slack. Although with 2% rate of interest and nearly 10 trillion dollars in debt its not infinite.

    Rumsfelds famous “unknown unknowns” are always lurking. But these unexpected events are what savvy financial marketeers make their money out of. Trading off volatility rather than momentum.

    More generally financial marketeers depend on market uncertainty about values to make their money. Which requires players to have an inside edge.

    The institutional set-up is in direct contradiction to the “perfect knowledge transparency” model taught to us at uni. Economics is the best social science. Its a pity that its sharpest operators seem to be working for the Masters of the Universe.

    The whole thing is a legalised white collar crime wave.

    “The scandal is not whats illegal. Its whats legal.”

    Michael Kinsley

  13. Obama probably isn’t up to the job. But he’s Wall Street’s only choice, since the alternative is too horrifying for even them to contemplate. An empty-headed rapture-ready armageddonist just one (senile melanoma-ridden 72 year-old’s) heartbeat away from the big red button? No thanks.

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