Batten Down the Hatches, the Financial Hurricane's On Its Way

As in a horror movie , just as you thought things could not get worse.. a more sinister and dangerous situation was brought out this week.

AIG (AIG) said in a SEC filing that the value of its credit-default swaps, used to hedge against fixed-income losses, fell by $4.88 billion in October and November, more than four times its prior forecast. Also in Monday's filing, AIG said it hasn't determined the amount of its fourth-quarter decline in the value of its credit swaps. Isn't that encouraging? Because back in December, AIG stated that its exposure was manageable and the stock rallied. However, this brings to mind one word: “Credibility".

The stock market shrugged off this issue possibly at least for now. However, there are $45 trillion of credit default swaps out there. A default on even a small percentage of this $45 trillion could cause an economic disaster.

It is very hard to believe it can not happen. It is almost rather not if, but when.

Somewhere in time, possibly a major bank, hedge fund, insurance company will declare bankruptcy or possibly a debt downgrade will trigger a claim on a swap. That claim will not be paid because either the underwriter such as MBIA (MBI) or Ambac (ABK) or others are not capable of paying the claim.

A domino effect of defaults will occur up the line on various corporations, universities, county governments or unknown others counting on that claim as part of their hedge.

The problem is based on credibility, counter party risk and liquidity. The current situation we are in is that investors as well as financial institutions do not trust their counterparties. Due to this fear, liquidity is impaired. More so, the next domino falls when counterparties suddenly decide to pull financing due to balance sheet constraints. More of a liquidity squeeze.

Next issue "Who wants to buy some of the paper floating around"?

Even 10 cents on the dollar can be over-paying for something worthless.

Again the Sage of Omaha has proven his genius. Warren Buffet has voiced his concern over exotic derivatives for many years. AIG is at the top of the iceberg. What is most concerning is the lack of quantification of potential loses out there.

Batten down the hatches... The winds of an upcoming financial hurricane seem to be picking up.