Ed Note: See comments below for updates on the themes sounded here across subsequent days and weeks into October. The cruelest month.
Very good overview in the Times of how credit default swap agreements got out of control at AIG.
Lehman, however, is/was in the same pickle — and the air in the Times story that the world just barely missed stepping off the cliff here is misleading.Â The bankruptcy of Lehman is pulling the world apart by the seams.
1.Â The culprits at Lehman are very much as described by the Times at AIG:Â a zillion outstanding swap agreements entered into by supposedly sequestered “specialty financial products” subsidiares (e.g., Lehman Brothers Special Financing, Inc.) — which swaps, however, were guaranteed in side letters by Lehman Brothers Holdings Inc., the corporate parent.
While AIG, an insurance company, seems to have focused on providing bond “insurance” by acting as Protection Seller in credit default swaps, Lehman, a broker-dealer, was more focused (in my experience drafting deals for them) on issuing not only mortgage bonds (Bread and butter, bread and butter …) but CDOs and similar as problem solvers for particular clients.Â (See What is a CDO? (I mean really).)
But every CDO and CMOÂ I’ve ever cast eyes upon was festooned with swap agreements:Â Interest rate hedge swaps. Interest cap swaps. Perhaps credit default swaps on assets in the CDO pool, or on collateral appended as “credit enhancement,” to sweeten the deal …
That is: the versatility of the ISDA swap agreement means it can be used to solve just about any problem — to bridge any gap between a hustling young so-called banker trying to close his first or second deal and the intended buyer(s) of the bonds produced by a securitization.
2.Â Three or four years ago my boss and I wondered aloud for a while what would ever happen if a Credit Event struck Lehman — thereby triggering termination of these zilion swaps.
“Credit Event”?Â E.g., a reduction in its long-term credit rating, for example, by Moody’s or S&P. Just a notch or two would do it.Â Never did we contemplate the parent’s bankruptcy.
3.Â This I think is what’s behind Bill Gross’s call Friday for the Fed to step up and act as a “clearinghouse” to “unclog the pipes” of the financial system.
That is: Simply because of the Lehman bankruptcy there are counterparties worldwide holding the bag on a zillion busted swaps — and in most cases probably in deals that until the bankruptcy filing were healthy.
E.g., a diversified CDO.Â Where mortgage bonds comprise no more than 3 or 4% of the assset pool (as was often the case in deals I drafted most of this decade). Credit card bonds 10% or 20%. Maybe no auto loan bonds at all. No Manufactured Housing loans.Â Half the pool in well rated corporate bonds.
Ie, a diversified pool of bonds and similar most of which were likely still performing when Lehman made its filing.
Disaster has now struck such deals, as the swaps that were built in to protect the investors (against, eg, big interest rate swings) have had their termination provisions triggered by the mother of all Credit Events (the guarantor-parent’s bankruptcy) — and thus money is due from Lehman but not forthcoming — and so the CDO itself (it says here) has to be wound up — which means selling the vast pool of bonds — into the worst credit markets we’ve ever seen.
In most deals probably no one wants to do that — neither the Lehman bankers nor the trustee with fiduciary responsibility for assets nor the portfolio manager nor the tranche investors.
So working something out — by bushwacking beyond the confines of the deal contracts — until the chaos subsides … This I imagine is what Mr Gross had in mind when he called on the Fed to function as a plumber and a clearinghouse.
(Something like this occurred when Delphi auto parts went under ca 2003 (if memory serves) and the world discovered a universe of swaps — now triggered by the collapse — that could not be settled by their own terms. What to do? The big boys got together and worked things out.)
4.Â Everyone says (could be wrong) that the weekend before Lehman filed bankruptcy, the CEO, Richard Fuld, gave the finger to his crocodile suitors offering dimes for dollars.Â (Primarily, Barclays of London — which since has been picking the carcass clean.)
Lehman at that moment was struggling to get delivery on a $17 billion line of credit with JPMorganChase — which had consumed Bear Stearns in March with $29 billion in aid from the Fed.Â Now, as Lehman floundered, JPM refused to put the $17 billion in the mail.Â (Lehman shareholders have since sued JPM.)
Fuld, in telling Barclays no deal, perhaps was relying on the JPM credit line and the history of fed intervention with Bear Stearns.Â In any case, by arriving at Monday morning with no deal done, he in effect challenged Paulson and Bernanke: Go ahead, I dare you. Let us fail.
And Paulson called the bluff.Â And Fuld filed bankrupctcy.
But, a day later, as the Times article makes clear, AIG in the same position dragged Goldman Sachs (which Paulson not long ago chaired) to the precipice. And Paulson blinked.
Or was it a wink?
That’s the piquant question — which the Times piece clearly alludes to.
But … There plenty more pressing questions at the moment on the table.
When one steps back to comprehend the wreckage of the Bush-Cheney years ….
Enron, Lehman, AIG, no doubt others, all involve, mechanically, a network of obligations entered into at outposts along the corporate periphery manned by young hustling so-called bankers or account executives, but which lead by circuitious roots to the parent.
In Enron it’s clear that criminal intent was involved in masking the public tallying of those obligations.Ă‚Â I haven’t seen anything yet to suggest same at Lehman or AIG.
– Ecstatic greed by the hustling young looking to be millionaires before their 30th birthdays.
– Blinding greed and laxity by senior managers overseeing the hustlers’ deals.
– Misplaced faith in the parent’s ability to handle its many splendored obligations, based in part on ignorance and willing blindness but also on
– professed faith in spreadsheet models that failed to predict high-stress (non) performance of MBS, CMOs, CDOs, etc. — in many cases (as already discussed in the press) because the models were tweaked to be forgiving … by hustling so-called bankers … and so-called senior managers … yadda yadda yadda …