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AIG Bailout, Part 2: Even More Uncertainty


Tax dollars backstop insupportable risk.

Many people have referred to the purchase of naked credit default swaps (CDSs) -- i.e. the purchase of CDSs for speculative purposes rather than to hedge the holding of the underlying debt -- akin to buying life insurance on your neighbor and then using legal tools (like debt and equity shorting) to run him over. Since CDSs carry boatloads of leverage, the speculator makes a killing.

As unsavory as the practice of naked CDS transactions may be, I'm against prohibiting it. It should be strictly regulated (hello, Mr. Government!), but not outlawed; any private party ought to be able to use/waste its money as it wishes - or else we may as well pick up the Rosetta Stone Russian language software and study it fast.

The only risks the spec runs in entering into a CDS contract is the loss of the premium paid to purchase the CDS, and the counterparty risk that the CDS seller may not make good on paying the CDS.

Last week, rumors swirled that we, the taxpayers, would explicitly backstop some $300 billion of American International Group's (AIG) CDS liabilities. In other words, we were going to use taxpayers' money to backstop the contractual risks of 2, well-defined private parties (not the small investor/public as has been the rationalization behind other bailouts).

But wait, there's more! In choosing to make good on the AIG CDS, we will, in fact, replenish the coffers of those who have had no small role in accelerating the unwinding of the financial system (we'll call them "sharks"), thus giving them fresh capital to press their bets to eternity. If you feel that we're entering the twilight zone, you're not alone.

Now, the likely response from the government would be that a lot of the "sharks" are in fact other systemically dangerous institutions - JPMorgan (JPM) doesn't have $40 trillion of notional derivatives exposure for nothing, and even if you offset a lot of those positions, the number is likely meaninglessly large anyway. Therefore, they need to backstop the domino effect.

Fine, I get that. But this brings me back to my article from Thursday: "Unless, in conjunction with the coming AIG bailout, the government legislates out existence of the transacting of speculative CDSs, the government will have handed $300 billion to bear speculators with which to escalate this financial crisis to a whole different level."

With this morning's revised bailout terms for AIG, the government may have seen at least part of the light and decided to affirmatively sidestep the issue. My read of the "silence" is that they're going to take the CDSs as they come due. So presumably, if a CDS hits and creates a loss, AIG will take the loss and the government will pay out. But I wouldn't assume that this is an open-ended process; it may be that if things get too ugly, they'll walk, backstop the whole thing, or maybe backstop just the CDS that are on the books of other systemically dangerous entities (JPMorgan?). Let's call it the next step in choosing winners and losers.

Of course, the mere perpetuation of this game of adaptive bailouts adds to uncertainty and to the damage to the markets, but that's for another piece. Stay tuned Minyans, and be prepared.
No positions in stocks mentioned.
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