A Morning Rant - EFSF, Enron, AIG, CDS Clearing

From Peter Tchir of TF Market Advisors

A Morning Rant - EFSF, Enron, AIG, CDS Clearing

We are still waiting to see the final form of the "Grand Plan" and what novel ways the EFSF guarantees will be applied to save the day.  At the risk of sounding incredibly stupid, I have this feeling that Europe didn't actually work on any details until this past week, and Germany is suddenly realizing how bad the details are for them.  Is it possible that some politicians got so caught in the moment of "saving Europe" and "fighting the speculators" that they kept promising more and more, without thinking whether they could or should deliver?  You would like to think they didn't, but since none of the politicians are detail oriented, most of their contacts at investment banks are high level, former bankers, rather than traders, it is quite possible they didn't realize what they had agreed to.  If some new EFSF is created, all of the future bargaining power in Europe will be shifted from France and Germany to PIIS.  (it is a shame Ireland wasn't named Shamrock, it would make the acronym so much better).

Did you know it is hard to find an MBIA bond wrapped by MBIA?  Investors didn't want to buy MBIA bonds wrapped by MBIA because except for some recovery games it was ridiculously circular.  Of all the things a wrapper cannot wrap is their own bonds.  There is no value in that.  Similarly, there aren't a lot of trades on JPM's book where JPM is the Reference Entity.  Who would buy JPM CDS from JPM?  Even with collateral provisions, it is all a bit too hairy, so investors wouldn't do it.

But EFSF plans to change all that.  Buy bonds of the worst EFSF countries and get a wrap from EFSF.  Buy protection on the worst EFSF countries from EFSF.  Enron used to like to use their own stock or credit to secure more credit.  Enron used to do deals where they would borrow money against their stock.  Some investors thought it was a great idea to use something lower in the capital structure to insure on something higher in the capital structure.  That was just one of the many convoluted games Enron played to get more financing than anyone realized they had.  It didn't work out great for Enron creditors.

AIG.  The poster child for what went wrong with CDS was a big fan of leveraging their AAA rating.  No collateral unless we get downgraded was their mantra.  That was ugly enough, but they were also masters of inter company lending.  AIG, AIG FP, ILFC, Banque AIG, were all entities to be used as needed to support each other.  The end result was a massive government bailout.  Who is going to bailout the EFSF since it is already the governments?

CDS is way too complex to be cleared.  Way to complex to be moved to a clearing corp.  The effort would be too massive.  What about legacy trades?  I have lost track of many of the arguments why almost 4 years after Bear Stearns, virtually no progress (other than in the eyes of some politicians) has been made in terms of clearing or exchange traded CDS.  Yet, TRX.II, some new CMBS index could be created and launched.  Of course it is not exchange traded because, ummm, ummm?  No legacy trades, so that part would have been easy.  It is a new product so could have been designed for an exchange format.  But no, just a new complex product that will be both opaque and problematic if we continue the downturn in CMBS.  I cannot tell if the product is trading, but it certainly seems a slap in the face to regulators.

I know the regulators and Basel will never do it, but if the EU can coerce banks into taking write downs on sovereign debt in a way specifically to avoid triggering CDS, should they still give regulatory capital relief to banks that have bought CDS?  The regulators and Basel are unlikely to change that any time soon, but investors will.  Soon, investors won't care about Net exposures.  They will want to know Gross exposures.  Forcing banks to take a big realized hit on Greece and not being able to execute CDS, will be another excuse for investors to trade banks further below "book value" as "book value" will be an even bigger joke than it already is, and will cause more concerns about capital ratios at banks.  If CDS effectively increases capital, why would the market give it any benefit knowing that on sovereigns at least, it is useless? 

There is a good Bloomberg story today about BAC shifting some CDS exposures into a different entity that is of higher credit quality than where the trades were booked.  Can't move these things to an exchange, but can move them into an entity that benefits the old buyers of protection at the expense of anyone who was taking credit risk at this better entity.  This was one way of getting around the fact that counterparties were nervous and were going to have to pull trades or buy CDS on BAC.  It seems more complex, less fair, and definitely more opaque than putting these trades all into clearing or on an exchange.

If anyone has any details on why exchange traded CDS has made no progress in almost 4 years since Bear, over 3 years since Lehman, and well over a year since Dodd-Frank.  I have no details of why not, but my guess is that they are bogged down over some complexities that affect less than 5% of the existing market, and if an exchange went ahead, over 99% of all trades would fit (the market does adapt to new concepts and will give up some customization if the benefit is greater liquidity).  It may be hard to believe, but it was only around 2000 that CDS started trading to IMM dates.  That innovation was fought by some and even caused some initial credit line issues, yet no one would think of going back to "true 5 year" CDS.  Physical Settlement was a criteria that some were adamant about - now  we have Cash Settlement Protocol built in.  The CDX indices didn't exist until October 2003.  It isn't rocket science.  It isn't easy, but it is do-able with some hard work and ingenuity.

To end with a quasi-positive note, I think MS will blow away their earnings estimates.  From what I can see, the highest estimate is 56 cents per share.  I bid 57.  Actually I think they could be well over $1.  Citi and JPM both had 1.9 billion of DVA.  They both have more debt that MS - 250 billion vs 190 billion, but MS spreads moved far more.  We have been combing through 10 Q's to do a reliable estimate, but "shockingly" the details on DVA are quite limited.  It is interesting that one could be the single biggest line item in bank earnings this quarter comes with virtually no details.  Actually, it is not shocking at all, but I really think MS will report a headline bigger than $1. 

In the meantime, I'm plugging away on some EFSF analysis. It would be great if there were some details so the work could be more focused, but guess that would be too easy.  It may also be, because no details are forthcoming because Germany has decided they like being in charge and giving directions to the PIIGS and don't want to be at their mercy.


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