What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup

On Friday, the FDIC closed and facilitated the sale of two CA savings banks, Downey Savings and Loan, the bank unit of Downey Financial Corp (NYSE:DSL) and PFF Bank and Trust, Pomona, CA. All deposit accounts and all loans of both banks have been transferred to U.S. Bank, NA, lead bank unit of US Bancorp (NYSE:USB). All former Downey and PFF Bank branches reopen for business todayàas branches of U.S. Bank.

Earlier this year we wrote positively about Downey and the funding advantages it had over larger thrifts such as Washington Mutual due to the solid deposit base and strong capital. Indeed, as of Q3 2008, the bank’s Tier One leverage ratio was over 7.5%, more than two points over the minimum, and its charge offs had actually fallen compared with the gruesome 400 basis points of default reported in the previous period.

But since the September resolution of WaMu and Wachovia, the FDIC, it seems, is not willing to wait to resolve institutions, even banks that are apparently solvent and not below any of the traditional regulatory triggers for closure. The visible public metrics indicating soundness did not dissuade the Office of Thrift Supervision and FDIC from seizing both banks and selling them to USB.

The purchase of Downey and PFF is good news for the depositors and borrowers, who will all be offered the FDIC’s prepackaged IndyMac mortgage modification program as a condition of the USB acquisition. Bad news for the investors and creditors, who now see their already impaired investments wiped out.

The resolution of Downey illustrates both the best and the worst aspects of the government’s remediation efforts. On the one hand, we have argued that the government should be pushing bad banks into the arms of stronger banks to improve the overall condition of the system. The good people at the FDIC do that very well – when politics does not intervene.

In the case of Downey and PFF, it appears that the OTS and FDIC projected forward from the current above-peer loss rates and concluded that a prompt resolution was required. Reasonable people can argue whether this is the right call. But when we see the equity and debt holders of DSL, Washington Mutual or Lehman Brothers taking a total loss, we have to ask a basic question: why is it that the debt holders of Bear Stearns and AIG (NYSE:AIG) are granted salvation by the Federal Reserve Board and the US Treasury, but other investors are not?

If the rule of driving money to the strong banks (see “View from the Top: A Prime Solution to the US Banking Crisis”) safety and soundness is to be effective, it must be applied to all. And now you know why we have questions about the nomination of Tim Geithner to be the next Treasury Secretary.

If you look at how the Fed and Treasury have handled the bailouts of Bear Stearns and AIG, a reasonable conclusion might be that the Paulson/Geithner model of political economy is rule by plutocrat. Facilitate a Fed bailout of the speculative elements of the financial world and their sponsors among the larger derivatives dealer banks, but leave the real economy to deal with the crisis via bankruptcy and liquidation. Thus Lehman, WaMu, Wachovia and Downey shareholders and creditors get the axe, but the bondholders and institutional counterparties of Bear and AIG do not.

Few observers outside Wall Street understand that the hundreds of billions of dollars pumped into AIG by the Fed of NY and Treasury, funds used to keep the creditors from a default,àhas been used to fund the payout at face value of credit default swap contracts or “CDS,” insurance written by AIG against senior traunches of collateralized debt obligations or “CDOs.” The Paulson/Geithner model for dealing with troubled financial institutions such as AIG with net unfundedàobligations to pay CDS contracts seems to be to simply provide the needed liquidity and hope for the best. Fed and AIG officials have even been attempting to purchase the CDOs insured by AIG in an attempt to tear up the CDS contracts. But these efforts only focus on a small part of AIG’sàCDS book.

The Paulson/Geithner bailout model as manifest by the AIG situation is untenable and illustrates why President-elect Obama badly needs a new face at Treasury. A face with real financial credentials, somebodyàlike Fannie Mae CEO Herb Allison.à A banker with real world transactional experience, somebody who will know precisely how to deal with the last bubble that needs to be lanced – CDS.

Last Thursday, we gave a presentation to the New York Chapter of the Risk Management Association regarding the US banking sector and the long-term issues facing same. You can read a copy of the slides by clicking here.

As part of the presentation (Page 17-21), IRA co-founder Chris Whalen argued the case made by a reader of The IRA a week before (see “New Hope for Financial Economics: Interview with Bill Janeway,”) that until we rid the markets of CDS, there will be no restoring investor confidence in financial institutions. Here is how we presented the situation to about 200 finance and risk professionals in the auditorium of JPM last week.à Of note, nobody in the audience argued.

1) Start with the $50 trillion or so in extant CDS.

2) Assume that as default rates for all types of collateral rise over next 24-36 months, 40% of the $50 trillion in CDS goes into the money. That is $20 trillion gross notional of CDS which must be funded.

3) Now assume a 25% recovery rate against that portion of all CDS that goes into the money.

4) That leaves you with a $15 trillion net amount that must be paid by providers of protection in CDS. And remember, a 40% in the money assumption for CDS is VERY conservative. The rise in loss rates for all type of collateral over the next 24 months could easily make the portion of CDS in the money grow to more like 60-70%. That is $40 plus trillion in notional payments vs. a recovery rate in single digits.

Q: Does anybody really believe that the global central banks and the politicians that stand behind them are going to provide the liquidity to fund $15 trillion or moreàin CDS payouts? Remember, only a small portion of these positions are actually hedging exposure in the form of the underlying securities. The rest are speculative, in some cases 10, 20 of 30 times the underlying basis. Yet the position taken by Treasury Secretary Paulson and implemented by Tim Geithner (and the Fed Board in Washington, to be fair) is that these leveraged wagers should be paid in full.

Our answer to this cowardly view is that AIG needs to be put into bankruptcy. As we wrote on TheBigPicture over the weekend, we’ll take our queue from NY State Insurance Commissioner Eric Dinalo and stipulate that we pay true hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches and pitchforks catch up to them.

President-elect Obama and the American people have a choice: embrace financial sanity and safety and soundness by deflating the last, biggest speculative bubble using the time-tested mechanism of insolvency. Or we can muddle along for the next decade or more, using the Paulson/Geithner model of financial rescue for the AIGàCDS Ponzi scheme and embrace the Japanese model of economic stagnation.

And, yes, we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into a quick and final extinction. Remember, when AIG goes bankrupt the insurance units are taken over by NY, WI and put into statutory receiverships. Only the rancid CDS positions and financial engineering unit of AIG end up in bankruptcy. And fortunately we have a fine example of just how to do it in the bankruptcy of Lehman Brothers.

Our friends at Katten Muchin Rosenman in Chicago wrote last week in their excellent Client Advisory: “On November 13, 2008, Lehman Brothers Holdings Inc. and its U.S. affiliates in bankruptcy, including Lehman Brothers Special Financing and Lehman Brothers Commercial Paper (collectively, “Lehman”) filed a motion asking that certain expedited procedures be put in place to allow Lehman to assume, assign or terminate the thousands of executory derivative contracts to which they are a party. If Lehman’s motion is granted, counterparties to transactions that have not been terminated will have very little time to react and will likely find themselves with new counterparties and no further recourse to Lehman because, by assigning contracts to third parties, Lehman will effectively receive, by normal operation of the Bankruptcy Code, a novation.”

The bankruptcy court process also allows for parties to terminate or “rip up” CDS contracts, something that has also been fully enabled by the DTCC. The bankruptcy can dispose and the DTCC will confirm.

BTW, while you folks in the Big Media churned out hundreds of thousands of words last week waxing euphoric about the prospect for enhanced back office clearing of CDS contracts, the real issue is the festering credit situation in the front office. Truth is that the DTCC and the other dealers, working at the behest of Mr. Geithner, Gerry Corrigan and many others, have largely fixed the operational issues dogging the CDS markets. The danger of CDS is not a systemic blowup – though that will come soon enough. It is the normal operation of the now electronically enabled CDS market wherein lies the threat to the entire global financial system, this via the huge drain in liquidity illustrated above as CDS contracts are triggered by default events.

The only way to deal with this ridiculous Ponzi scheme is bankruptcy. The way to start that healing process, in our view, is by the Fed emulating the FDIC’s treatment of DSL, withdrawing financial support for AIG and pushing the company into the arms of the bankruptcy court. The eager buyers for the AIG insurance units, cleansed of liability via a receivership, will stretch around the block.

By embracing Geithner, President-elect Barack Obama is endorsing the ill-advised scheme to support AIG directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. News reports have already documented the ties between GS and AIG, and the backroom machinations by Paulson to get the deal done. This scheme to stay AIG’s resolution cannot possibly work and when it does collapse, Barak Obama and his administration will wear the blame due through their endorsement of TimàGeithner.

The bailout of AIG represents the last desperate rearguard action by the CDS dealers and the happy squirrels at ISDA, the keepers of the flame of Wall Street financial engineering. Hopefully somebody will pull President-elect Obama aside and give him the facts on this messàbefore reality bites us all in the collective arse with, say, a bankruptcy filing by GM (NYSE:GM).

You see, there are trillions of dollars in outstanding CDS contracts for the Big Three automakers, their suppliers and financing vehicles. A filing by GM is not only going to put the real economy into cardiac arrest but will also start a chain reaction meltdown in the CDS markets as other automakers, vendors and finance units like GMAC are also sucked into the quicksand of bankruptcy.àà You knew when the vendor insurers pulled back from GM a few weeks ago that the jig was up.

And many of these CDS contracts were written two, three and four years ago, at annual spreads and upfront fees far smaller than the 90 plus percent payouts that will likely be required upon a GM default. That’s the dirty little secret we peripherally discussed in our interview last week with Bill Janeway, namely that most of these CDS contracts were never priced correctly to reflect the true probability of default.à In a true insurance market with capital and reserve requirements, the spreads on CDS would be multiples of those demanded today for such highly correlated risks. Or to put it in fair value accounting terms, pricing CDS vs. the current yield on the underlying basis is a fool’s game. Truth is not beauty, price is not value.

If you assume a recovery value of say 20% against all of the CDS tied to the auto industry, directly and indirectly, that is a really big number. The spreads on GM today suggest recovery rates in single digits, making the potential cash payout on the CDS even larger.

As Bloomberg News reported in August: “A default by one of the automakers would trigger writedowns and losses in the $1.2 trillion market for collateralized debt obligations that pool derivatives linked to corporate debtââ¬Â¦ Credit-default swaps on GM and Ford were included in more than 80 percent of CDOs created before they lost their investment-grade debt rankings in 2005, according to data compiled by Standard & Poor’s.”

At some point, Washington is going to be forced to accept that bankruptcy and liquidation, the harsh medicine used with other financial insolvencies, are the best ways to deal with the last, greatest bubble, namely the CDS market. When the end comes, it will effect some of the largest financial institutions in the world, chief among them Citigroup (NYSE:C),àJPMorganChase (NYSE:JPM),àGS and MS, as well as some large Euroland banks.

The impending blowback from a CDS unwind at less than face amount is one of the reasons that the financial markets have been pummelingàthe equity valuesàof the larger banksàlast week. Any bank with a large derivatives trading book is likely to be mortally wounded as the CDS markets finally collapse.à We don’t see problems with interest rate or currency contracts, by the way, only the great CDS Ponzi scheme is at issue – hopefully, if authorities around the world act with purpose on rendering extinct CDS contracts as they exist today. Call it a Christmas present to the entire world.

Indeed, as this issue of The IRAàgoes to press, news reports indicate that C isàin talks with the Treasury for further financial support under the TARP, including a “bad bank” option to offload assets. A bad bank approach may be a good model for applying the principle of receivership to the too-big-too fail mega institutions, but the cost is government control of these banks.

Q: Does a “bad bank” bailout for C by Treasury and FDIC qualify as a default under the ISDA protocols!?

We’ve been predicting that Treasury will eventually be in charge of C.à On the day the government formally takes control, we say that Treasuryàshouldàand hire FDIC to start selling branches and assets.à Thus does the liquidation continue and we get closer to the bottom of the great unwind. Stay tuned.

21 Responses to "What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup"

  1. astonished   November 24, 2008 at 10:46 am

    If Citi is being rescued why are it’s 50,000 employess not being reinstated ?

    • Anonymous   November 24, 2008 at 10:49 am

      The 50,000 should consider themselves lucky that they are not being returned to this burning house!

  2. Anonymous   November 24, 2008 at 10:48 am

    This is by far the clearest, as well as the most sobering explanation of CDS and what must be done that I have seen to date in print form.God help us all!

    • Robert C.   November 29, 2008 at 9:43 pm

      I’ve argued that those CDS contracts that represent a valid insurance/hedging contract against the owher’s risk should be honored, while CDS contracts held as naked bets (by those with no “insurable” interest) should be judicially declared “unenforceable – as gambling contracts – and contrary to public policy.”The public policy argument wins – naked CDS contract must fall. Give the holders back their “premiums” only. They deserve not a penny more.

  3. ex VRWC   November 24, 2008 at 11:13 am

    And the didn’t do a bad bank model. They cannot. Instead, their approach is to sweep it under the rug, provide guarantees that cannot possibly be backed up by an insolvent national treasury and Fed, and hope for the good times to return. But they won’t, and we will drain whatever remains of our treasury bailing out what is insolvent while fearing and refusing to recognize the day of reckoning.Has anybody thought about what the US will do when its dollars are worthless? Who will send us oil for worthless dollars? How will we transport our food to stores without oil? Who will send us our electronic components for worthless dollars? What will we export to be of value to the world?The dereliction of those who have the ability to choose another road in this mess is breathtaking. The descent will be mind-numbing.

  4. Siggy   November 24, 2008 at 11:31 am

    Indeed, why payout the risks that were taken in writing the paper. Smells like someone at AIG should go to jail. Did they not write contracts that they could not honor? Is that not a felony? We are down the rabbit hole and things are not brillig!

  5. Anonymous   November 24, 2008 at 12:49 pm

    The list of “somebodies” that should go to jail is endless. In my mind, every Bank and Wall Street Senior Manager or Board Director should be in jail, or at least penniless at this point. Instead, Obama is giving them cabinet posts. His idea of change is a joke. The crimes that have been commmitted against this society are supposed to be fixed by the “friends” of those that committed the crime. God help us!

  6. Lloyd Gillespie   November 24, 2008 at 1:48 pm

    Everyone should send “certified mail” letters to Pres. E. Barach Obama, enclosing links to Chris’s last two articles about the absolutely coming derivatives crash, I’ve been forcasting for the last 15 years. That way he’d have to get the message, as he’s required to sign all certified mail, personally___Know what I mean…?Start sending guys and gals…

  7. Payam   November 24, 2008 at 6:19 pm

    Chris,No serious economist agrees with you. On a system based on trust, you cannot allow CREDITORS to lose their money. That is asking for a depression.

    • anton kleinschmidt   November 25, 2008 at 4:20 am

      These serious economists are part of the toxic symbiosis of fools(Politicians, regulators, bankers, economists, academics and bureaucrats) that helped to create this mess in the first place

    • Guest   November 28, 2008 at 8:48 pm

      p, are you saying every speculation or wish should be granted in bubbleville? is that the new economics?

  8. Larry M.   November 24, 2008 at 6:38 pm

    In a system based on trust, you should be able to rely on money owed getting paid back to the extent your counterparty is solvent. You are responsible for assessing the viability of your counterparty (i.e. CDS issuer). Free markets cannot magically create money. Only centrally-controlled economies do that.

  9. Payam   November 24, 2008 at 6:44 pm

    On a system based on trust, innocent companies and people get hurt in a panic.Do you understand this? Many CDS issuers are hurt(well at least spreads have grown drastically) even w/ respect to contracts written on good companies or bonds. The problem is that if the credit market dries up, even these good companies can run into trouble, especially when they rely on short term debt.A good thing that is happening is that many of these companies are shaping up, even with the moral hazard. I don’t think something like this with respect to banks can happen again. What happened in the 30s was a run; we have protected against that. Now we need to protect it against modern finance; that is happening as we speak.

  10. Anonymous   November 24, 2008 at 10:41 pm

    Obama has panicked in picking Geithner. The bailout fix-it man is not the person for Treasury. He should be kept as far away from the national purse as possible. Problem is, Obama is clueless and beholden to Wall Street. Bad combination.

  11. AG   November 24, 2008 at 11:57 pm

    The government could publish a pay out table indicating the amount that the government would pay to CDS holders. Two key criteria would be used to determinepayout amounts. Actual bondholders would receive the highest payout ratio thosemerely speculating the lowest. Swap counterparties who underpriced their swaps(according to agreed upon standards) and did not have the reserves to guarantee pay out would receive less than those who were more accurate in their risk pricing and had a higher reserve amount/swap amount ratio.Historical data to establish the standards for the two criteria that would determine pay out amounts would be easy to confirm and difficult to dispute. This would restore transparency and certainty to the market.Yes contracts would be broken but not arbitrarily. Under the current haphazard response the government uses no explicit criteria to indicate which counterpartiesget supported and which ones don’t. While many counterparties, particularly themore speculative, would be disappointed, at least there would be a higher degree of predictability and fairness. The policy response would reward direct stake and prudence and punish speculation. In most established and regulated insurance markets isn’t that what we have? Why expect less from the CDS market?Please share your comments regarding this analysis and policy recommendation. Ismy understanding limited is the proposed response fatally flawed in some way?

    • Greenlight   November 25, 2008 at 12:26 pm

      AG, I’m with you on this! You’ve posed a serious approach, and while Secretary Paulson continues to insist that “these things are much more complicated,” in the end, it’s time to cut the Gordian Knot.Last night on CNN, the NY Insurance Commissioner stated that they were aware which 20% were legitimate risk transfer hedges, and which 80% were what the firms call “directional bets” — casino bets your firm can’t cover. If it turns out that Treasury is not madly at work on estimating the net effect of annulling these contracts, they have truly been fiddling like imbeciles while Rome burns. It’s time, as a matter of fact, to ask for the data. THAT would at least focus the markets again with a solid read of the underlying value of firms in the market.What I trust is that most firms have written off these obligations already in trying to assess their balance sheets going forward — both what they’re owed and what they owe. With that in mind, if we adopt your plan, then the 20% who made a legitimate risk-transfer hedge are reassured by the scope of Federal guarantees, and the 80% who have to see the loan shark will be chastened or bankrupted, as they should be. On balance, since these are non-performing assets, I think we can start with the premise that most firms will heave a huge sigh of relief when the CDS contracts are annulled.These instruments are funny money, not Federal Reserve Notes. After the Civil War, all Confederate currency was annulled — why shouldn’t this be?

  12. Payam   November 25, 2008 at 12:33 am

    I think anyone who wrote CDS on financial institutions or who received insurance on them should always taken into consideration the historical relevance of government intervention to save financial institutions worldwide.In terms of the pricing, I believe the Derivatives and swaps organization(or whatever they hell they’re called) managed to come up with a good solution with Lehman. In fact, they would probably be the arbiters and solution to every issue that arises. They basically govern what the payout ratios should be, etc.Putting swaps onto an exchange should alleviate any future problems that may arise in this huge market, as it will definitely shrink it.

  13. Matt Chanoff   November 25, 2008 at 1:05 am

    Very interesting discussion, but I’m wondering if the back-of-the-envelope calculation of $15 trillion of outstanding obligations takes into account netting. My understanding is that a lot of the speculative players in the CDS game hedged, taking short and long positions in the insurance. Didn’t the actual Lehman payout come to some very small fraction of the outstanding obligations for just this reason?

    • Payam   November 25, 2008 at 12:59 pm


  14. PTAMomfromMaryland   November 25, 2008 at 8:45 am

    I want 970 (435 x 2) citizen legislators to run in 2010 for Congress. 1 Dem and 1 Rep in each Congressional District. If a current congressman/woman is a “citizen legislator” then the 1 Dem and 1 Rep candidate can support their reelection.The wasted money and effort and the neglect of real priorities that self serving politicians have perpetuated over the years is cruel and corrupt.

  15. Anonymous   November 30, 2008 at 6:01 pm

    i don’t believe anyone who claims that these contracts are in the 10’s of trillions. who exactly bought 10’s of trillions of this crap? i never hear about anyone collecting on this stuff. only that everyone sold them. where are the owners?