This may be a stupid question, but who is it that's having credit events that are triggering CDS's to pay out? We all keep reading about Govt dollars flowing through AIG to their CDS counterparties. However, I cannot think of any huge bankruptcies that might be triggering CDS payouts on that scale. Or is AIG just unwinding it's CDS positions, and given that default likelyhoods are now much higher it's just really really expensive to buy their positions back (and they're using taxpayer $ to do it)? How about this last round a month or two ago, where European banks (and Goldman) got something like $40B. Who had a "credit event" that triggered these payouts? Lyondell? Equistar? Nortel? I mean these are fairly big names, but enough to cause a 40 billion payout? Also, we used to hear about the ISDA clearing auctions of the CDS's, but I haven't heard anything lately. Did they go underground or something? Maybe I've been living under a rock or something, but I haven't really heard.
I thought the "credit events" were basically margin calls. As different products became illiquid, lost value, counterparties required more collateral.
I didn't realize that CDS's were marginable. As a margin call, the $ would return as the contract period ends, (unless there is a default). Interesting to think about requesting margin cash from my insurance company becuase the likelihood of my house burning down is higher in the summer than in the winter. Unlikely that they'd do it... lol
AIG is posting collateral. Depending on the setup of the credit shop at AIG, typically it would be under a subsidiary entity funded with capital. If the entity posts collateral, then it would be extremely sensitive to MTM. In other words, even though the CDS contract may be on a very reliable company (ie. GE), the CDS spread can vary widely. When the spreads widen to a level that is higher than the initial level that the entity sells/bought protection at, you have a MTM difference (ie. the difference between the current CDS spread and the initial CDS spread the CDS contract was bought/sold at). The killer is that the MTM is cash settled everyday so if the position is not hedged, then there is a lot of capital that will move in and out fo the company daily. AIG's and many other shop's problem is that no one forsaw spreads going out this wide and therefore never anticipating having to post such large amounts of capital. AIG's second prob was that there MUNI GIC biz, although it was money good, required AIG to effectively "cure" the principal when the value of them decreased. So on one side, AIG had to post collateral (ie. cash) to offset MTM credit losses which triggered short fall in their Muni GIC biz that forced AIG to find additional capital cure the GICs. The reason for the Muni GIC requirement is because it is capital that pays for the majority of a municipalities' infrastructure.
^ Thanks for the detailed writeup. I am quite familiar with MTM and margin calls. If the $40B were just in margin cash as CDS rates increased, then all of it will return as the rates retrace, or as the term of the CDS ends. Regarding the Muni's, are they defaulting on their payment streams? If not, then even if increased marign is posted it doesn't really cost AIG much, especially since interest is paid on margin cash (but you have to have enough cash to post, lol)... I am still struggling with this, as the frequent message (especially around here) is that AIG bailout is going straight to banks' bottom lines. I'm sure some of it is, as CDS's pay out for real credit events, but if most of this is just margin cash posting, then there's no realized loss. I guess the Banks are reporting MtM gains on something that will not materialize unless there are actual defaults???
oh and regarding "curing the principal" on Munis: really???? If I buy a Muni bond and the yield on it in the secondary market gets bid up there's an insurer to make up the lost principal? It doesn't want to enter my head. I know there's an insurer that guarantees the municipality wont default on their coupons, but they guarantee the bonds price on resale??
Yes, that was a business model for a few IBs and insurers. Not the case any more, though, that's for sure... Take a look at this for a more detailed explain: http://accruedint.blogspot.com/2009/04/muni-swaps-lets-hope-we-dont-have.html
Why are they (AIG) paying outmargin calls if they can now use mark to model and mark to make believe.
Thanks for that excellent link. Seriously, one of the most interesting I've read in a while ( I actually like to be proven wrong, as long as I learn something...). So the difference between a VRDB and an auction rate security is that the ARS does not require the letter of credit? Also, can ARS's be put back to the issuer at par? Seems like a risky game for municipalities to be entering into. I think selling variable rate debt and a swap sounds like a great deal if the total cost is below a fixed rate offering. However the provision allowing the bond-holder to put it back at par value would make it a no-go in my mind. Also the variable leg of the swap set at an index that can differ from the actual rate incurred seems to be somewhat risky. I guess the Munis that were issuing these were relying on their bankers for advice.... I wonder why arbitrageurs wouldn't keep the interest rates on the VRDB's low. I mean if I saw a bond I could buy for 7 dollars with the right to put it back to the issuer at 9 dollars I would do both in an instant. I would even go to auctions to buy them up if it turned out that I could immediately put them back as the interest rate rose... I wonder why this usualy reliable market mechanism failed in these circumstances... thanks again for the great article.