This mornings must read article is via the NYT’s Gretchen Morgenson and Vikas Bajaj on Credit Default Swaps: MBIA Debt Is Setting Up a Quandary.
Here’s the Ubiq-cerpt:™
"The risks associated with the vast, unregulated market for credit default swaps played a crucial role in the bailout of Bear Stearns. Now these financial instruments are taking center stage in another Wall Street drama: whether regulators will let MBIA, the big bond insurance company, renege on a promise to shore up a crucial unit with $900 million in capital.
MBIA has written $137 billion in swaps, which are privately traded insurance contracts that let people bet on companies’ financial health. Most of these contracts stipulate that if MBIA’s bond insurance unit becomes insolvent or is taken over by state regulators, buyers can demand payment immediately.
But if that were to happen, MBIA would have far less money to pay policyholders and owners of municipal bonds backed by the company. So the swaps give MBIA significant leverage over Eric R. Dinallo, the commissioner of the New York State insurance department, who wanted the company to bolster its insurance unit with the $900 million in cash.
In the case of Bear Stearns, the Federal Reserve feared that credit default swaps might unleash a chain reaction of losses if the bank were allowed to collapse. Given the threat that similar swaps may pose to MBIA, Mr. Dinallo is unlikely to push for a regulatory takeover of the subsidiary even if Joseph W. Brown, MBIA’s chief executive, refuses to recapitalize the unit."
Its a variation of the old joke, writ much much larger: If you owe the bank $100 dollars, its your problem — but if you insure/underwrite $137 billion in swaps that you cannot possibly make good on, well then, its the Bank’s problem — or in this case, the Federal Reserve’s and the New York State insurance department concern . . .
UPDATE 2: June 19, 2008 5:59am
MBIA seems to be playing fast and loose with the truth in responding to the NYT
MBIA Lies in Attack on New York Times
JUNE 19, 2008, 5:10 AM
UPDATE: June 18, 2008 3:47pm
See this WSJ article for more on a related issue:
More than a year after the first stirrings of the credit crunch, the financial community is still short on trust.
Soon, there may be a market to trade on exactly how
short, as credit-market aficionados look to exploit the pervasiveness
of counterparty risk in a still-fragile investment climate.
Counterparty risk refers to the possibility that a
trading partner runs into trouble and is unable to fulfill the
obligations on its derivatives contracts. Given the billions of dollars
of write-downs at major banks and brokers, as well as the enormous size
— $62 trillion — of the over-the-counter derivatives market, such
risk isn’t taken lightly by financial markets still concerned that the
credit crunch isn’t over. —WSJ
MBIA Debt Is Setting Up a Quandary
GRETCHEN MORGENSON and VIKAS BAJAJ
NYT, June 18, 2008