On Goldman and CIT: No Free Lunches 13 comments
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I have commented on the interconnected counterparty risks in the banking and shadow banking system. Tidbits are now coming out in the news. Any time a big lender defaults, another big lender (or three will be on the hook for it).
Goldman Owed $1 Billion if CIT Goes Bankrupt: Report
The report said Goldman (GS) would be owed the payment under a $3 billion rescue finance package it gave to CIT in June 2008, before the U.S. government bought $2.33 billion of CIT preferred shares in December.
According to the FT, CIT "would be required to pay a make-whole amount" that totals $1 billion under that agreement.
Goldman is likely to agree to allow CIT to delay payment on some of the amount, according to the report. Beyond the $1 billion payment from its rescue package, Goldman would also receive payment from credit insurance it holds if CIT were to go bankrupt.
Of course, that credit insurance was most likely a swap and not true insurance, thus opens Goldman up to counterparty risk down the line, and so on and so on. See "As the markets climb on top of one big, incestuous pool of concentrated risk..." and "Any objective review shows that the big banks are simply too big for the safety of this country".
From the FT:
The relationship between Goldman Sachs and ailing commercial lender CIT provides further evidence that the credit default swap market can put a company in jeopardy.
Credit default swaps have become an increasingly contentious issue in debt restructurings such as the one that CIT is now trying to complete. Many creditors who hold such insurance make more if a company files for Chapter 11 bankruptcy protection than they make on their debt if the company succeeds in restructuring its debt outside of bankruptcy.
In the case of CIT, market players have bought more insurance than the company’s $30bn in debt. Those holders include Goldman, who purchased such a credit protection to hedge against a June 2008 rescue financing of up to $3bn to CIT, Goldman said. Goldman also held other CIT debt, although the company declined to comment on these other exposures.
Again, there are no free lunches. If Goldman does win that big, the guys on the other side of the swaps must lose equally big. Then they have to pay. Intro, counterparty risk. There are also the repercussions of the rapid decline in collateral quality. It directly effects the valuations, or at least the perception of valuations, of the collateral held by CIT competitors, namely commercial and community banks, who don't need any more asset devaluation issues.
But regardless of Goldman’s intention, it would profit handsomely if CIT were to file for bankruptcy protection. Before the company could even arrange the so-called debtor in possession financing to survive in bankruptcy, it would have to pay Goldman $1bn – as part of a make whole agreement – while Goldman’s valuable credit insurance would pay off at once.
To many analysts, the fact that such insurance can mean that a group of holders have an incentive to see a company file for Chapter 11 is perverse. The matter is delicate – it is always difficult to draw a distinction between hedging and speculating. What begins as hedging may end up being the opposite – the outcome market players are hedging against becomes the preferred outcome.
And what if CIT either can't or won't pay Goldman, as its collateral falls towards the zero mark? Goldman calls upon its CDS counterparties. Who would have been silly enough to write the other side of those swaps is beyond me, but they must have been hedged up the wazoo, just like Goldman. This begs the question, if everyone was doubtful about CITs prospects, and everyone that dealt with them was overcollaterized and thrice hedged, who the hell is the last guy in line ultimately responsible for payment if and when CIT goes bust?
Probably the taxpayer, but then again, what do I know?
In other news...
US Officials Exaggerated Banks' Health: Watchdog.
Reuters
| 05 Oct 2009 | 02:54 AM ET
Senior U.S. officials deliberately created the impression last year that banks receiving huge government cash infusions were healthier than was the case, a Treasury Department watchdog's report released Monday said.
As a result, the government and the bailout lost public credibility when the financial crisis deepened. Actually, after reading the comments section on popular sites such as Seeking Alpha, it appears as if the government did a decent job of pulling the wool over the populace's eyes. They may have lost credibility in the eyes of professional fundamental investors, but then again how much credibility did they have in those circles to begin with?
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke said at the time that their dramatic force-feeding of $125 billion into nine banks in October 2008 was a program for "healthy" institutions.
Go figure. I've been saying this for some time now. See "Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux" as well as
The Treasury with their stress tests, lacking any form of realistic stress:
The FASB allowing politicians and special interest groups tell them how to perform accounting, to the beneficial interest of the banking lobby, of course: see: The Folly of US Financial Poitical Games.
The Fed and thier "shroud of secrecy to prevent unfounded rumors from being created from founded facts", see The Fed Believes Secrecy is in Our Best Interests. Here are Some of the Secrets.
Disclaimer: As usual, I am short what I am bearish on, and long what I am bullish on - as it should be. Would you trust me if it was any way else?
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It's a makewhole, not cds protection.
"In the case of CIT, market players have bought more insurance than the company’s $30bn in debt. Those holders include Goldman, who purchased such a credit protection to hedge against a June 2008 rescue financing of up to $3bn to CIT, Goldman said. Goldman also held other CIT debt, although the company declined to comment on these other exposures."
So what's the big deal?
The article is about risk concentration so whether the CDS is a hedge or not, there is still a counterparty on the other side of the transaction. 5 banks hold 97% of the notional value of derivatives. I bet all 5 of those banks have CDS positions on CIT. Thus, exactly how is that risk truly hedged versus simply being shuffled around in a game of counterparty risk musical chairs.
The other big deal (although not nearly as big) is that it is not truly an economic hedge if the payout from the hedge is greater than the payout on the hedged transaction. Economically, it is a speculative position. Don't consider it a game of semantics for it creates an inverse incentive for GS when they benefit more from the collapse of underlying than they do from the repayment of the loan.
Out of interest, why does there have to be a last guy? Couldn't there be 50 or 100 institutions collectively on the hook for this?
The meltdown scenario is interesting, but I would think the impact has to depend on the shape of the interconnections? Sure, if bank A guarantees CIT 100% and bank B guarantees bank A 100% there will be a quick domino. But if this quickly resolves into the entire market being on the hook, then what's another $30 billion?
You didn't mention it, but Goldman is lobbying heavily to avoid congressional action to put some teeth into stopping naked shorting. Matt Taibbi has an article coming on this in Rolling Stone.
How to get rich:
1. Buy a pile of CDS contracts on company x.
2. Naked short company x stock into the ground.
3. Lack of common equity value dries up credit availability.
4. Chapter 11 filing results.
5. Collect on the CDS contracts.
Where does the money come from? The government prints it and puts it into banks. The banks use it to carry on their CDS scams.
Okay, so this is an oversimplification. However, it is valuable for illustrative purposes. There are perverse incentives at work here.
Good job in keeping attention on these problems, Reggie.
Good point!
Just as there is very little transparency in price discovery, the clearing arrangements are totally opaque and net off potential is completely masked. How do you know the 5 banks with 97% notional aren't individually net flat? I'm sorry if you think this is a ridiculous question, but it has to be asked.
AIG's new CEO is getting $10 million plus $4 million stock options and $2-1/2 million performance bonus. Whatever, it's only the taxpayer's money.
You have "literally" no idea how markets work dude
On Oct 06 09:06 AM Reggie Middleton wrote:
> You comment as if you haven't read the article. The big deal is that
> CDS are a ponzi scheme ready to collapse. There is no cash market
> for price discovery, hence the dealers can literally construct pricing
> due to opacity. There is extreme concentration risk in derivatives
> in general, and CDS as a subset.
>
> The article is about risk concentration so whether the CDS is a hedge
> or not, there is still a counterparty on the other side of the transaction.
> 5 banks hold 97% of the notional value of derivatives. I bet all
> 5 of those banks have CDS positions on CIT. Thus, exactly how is
> that risk truly hedged versus simply being shuffled around in a game
> of counterparty risk musical chairs.
>
> The other big deal (although not nearly as big) is that it is not
> truly an economic hedge if the payout from the hedge is greater than
> the payout on the hedged transaction. Economically, it is a speculative
> position. Don't consider it a game of semantics for it creates an
> inverse incentive for GS when they benefit more from the collapse
> of underlying than they do from the repayment of the loan.
On Oct 06 09:27 AM John Lounsbury wrote:
> How to get rich:
>
> 1. Buy a pile of CDS contracts on company x.
> 2. Naked short company x stock into the ground.
> 3. Lack of common equity value dries up credit availability.
> 4. Chapter 11 filing results.
> 5. Collect on the CDS contracts.
>
> Where does the money come from? The government prints it and puts
> it into banks. The banks use it to carry on their CDS scams.
>
> Okay, so this is an oversimplification. However, it is valuable for
> illustrative purposes. There are perverse incentives at work here.
>
>
> Good job in keeping attention on these problems, Reggie.
Let's use CIT as an example. If all 5 banks have CDS positions in CIT, and Goldman has a billion dollar CDS purchase, then in order to net, the other 5 would have to have $1billion on the other side. The problem is that it appears nearly everybody bought CDS on CIT! There are no chatterings about entities that sold more CDS than CIT has debt, now are there? There appears to be significantly more CDS written on CIT than CIT has net debt, or gross debt. This begs the question, "who is on the other side"?
An even more tantamount question is what is the credit quality of those guys who did write the CDS? If they are just a bunch of $100 million hedge funds holding several billion dollars of CDS risk, then there you go. If they are one of these 5 banks who have hegded their risk with the other 4 banks who hedged their risk with the other 3 banks who relied on those first 2 banks to hedge their risk, well then there you go!
I don't know if all 5 bank are net flat, but I doubt so very seriously. I have went through nearly all of their balance sheets, and one (I have released one bank in particular to my subscribers) have written more than a quarter of their TCE in naked CDS, just like AIG did!
If they are all net flat, then has any risk truly been transferred or are they passing the buck around a circle of 5? I can understand a circle of 50,000, but 5???
Okay, smarty pants. Why don't you educate us on how a CDS is priced on the ABX, and exactly what the tracking error, if any, is on the actual liklihood of an event of default? What is the definition of default on the contracts written on the ABX?
You can also explain to us if there is any discrepancy and/or relationship between the actual credit default (or its probability) and the ability of the trust to pay out to avoid default.
I admit that I am a neophyte in practically all things, so my ears are open.
You say I know nothing of how markets work, but the CDS space is not truly a market, it is a space run purely by an oligarchy of broker/dealers with the Golden formula of pricing/clearing/settl... A true market has price discovery emanating for asks and bids between all members of a community, not gate keepers on Wall Street. Think stock market, housing market, bond market, currency market.