There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities. As an aside, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Care to make an over/under wager on a 1% loss by this time next year? I don’t think I would want the under.

Gretchen Morgenstern reported last week that there are - drum roll - $62 trillion (with a “T”) in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt. Even if you cut this in half - because technically, when a buyer and a seller enter into a single transaction they create twice the value of the transaction in credit derivatives - this is a huge sum, far out of proportion to the underlying assets. More on this later.

The team at Morgan Stanley (MS) has a very interesting problem to solve. It is not just about putting $25 to $50 billion into Fannie and Freddie (assuming that would be enough). If that’s all it was, just issue preferred shares, wipe out the current shareholders and, as the smoke cleared in a few years, even with less leverage the actual value of the two companies might actually approach that number and some private equity firms could take out the US taxpayer. But it is not that simple.

What do you do with the current preferred shares? A significant portion is held by banks in their capital base. JP Morgan Chase just wrote down $600 million in Fannie and Freddie preferred shares this week. Many other banks will be doing so as well. As noted last week, there are banks that have more than 20% of their capital base in these shares. In today’s current environment, do we want to deal with the costs to the FDIC of even more failed banks? And even if you don’t force a bank into outright failure, you at best limit its ability to function as an efficient market lending agency to local businesses and consumers.

But you can’t just say, “We will cover the preferred shares in banks but not in personal accounts or in the accounts of other institutions.” It is an all or nothing proposition. A $36 billion proposition. It is a potential Hobson’s choice. Wipe out the preferreds or wipe out the shareholders of a lot of banks and have the FDIC pick up the costs. By the way, Congress and bank regulators encouraged banks to buy preferred shares by giving them special status and tax breaks.

But what about the $19 billion subordinated debt? That $19 billion is actually on the banks’ books as capital for Fannie and Freddie and not as debt, because there is a clause in the bond that says if the bank is in a situation where it must be bailed out, the interest payments on those bonds can be postponed for five years. That allows them to count the debt as capital. If the companies are declared insolvent by their regulators, it could trigger the credit default swaps.

I say could, because depending on how the “credit event” is characterized, it may allow the seller of the insurance to postpone payment for five years as well. Just a technical loophole that I am sure most buyers of said credit insurance did not notice.

And even then, I think it is unlikely that many of the sellers of such credit insurance could make anywhere close to the amount of payments they have contracted for. And since the subordinated debt is precisely what you would want to buy credit insurance on, I bet a disproportionate amount of that $62 trillion in credit default swaps is on the lower-rated debt.

Who Is Holding the Old Maid?

And here’s the ugly truth. No one knows who is ultimately on the hook for these derivatives. If I sell a credit default swap (CDS) to you and then buy a CDS on the same issue from Joe down the street for a small profit, my “book” looks neutral. And as long as Joe has the capital, I am. But at 12 times the actual underlying debt instruments, there are not just three parties to my mythical transaction, but at least 10. Joe sells to Mary who sells to Bill, etc., etc. Where does the real guarantee ultimately reside?

Like the children’s card game, someone is stuck with the Old Maid at the end.

If there is a problem, you are going to come to me but I am going to tell you to go to Joe who will tell you to go to Mary and on down the line until someone tells you to go to hell. Then you come back at me and take me to court. That’s the way it works.

This is why I keep pounding the table that CDS transactions must be moved to a regulated exchange. There has to be transparency and provisions for adequate capitalization of these instruments. Bear Stearns was too big to fail not because it was too big, but because of its derivative book of $1.9 trillion. We would have awoken on that Monday morning and, if Bear had been allowed to fail, the markets would have been frozen, because no one knew who was on the hook to Bear (and vice versa) and for how much. And if you don’t know, you don’t invest or lend to any financial institution or fund, because you put yourself at more risk.

Pages: 1 2 3 4

Pages: 1 2 3 4