Do We Need to Cancel ALL CDS Contracts?

Last night, I 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 my slides by clicking here.

As part of the presentation (Page 17-21), I argued that until we rid the markets of CDS, there will be no restoring investor confidence in financials. Here is how I presented the situation to about 200 finance and risk professionals in the auditorium of JPM last night.  Of note, nobody in the audience argued with me.

Start with the $50 trillion of so in extant CDS.

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.

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

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 is VERY conservative.  Could easily be 60-70%.

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 in CDS payouts?  Remember, less than 10% of these positions are actually hedging exposure.  The rest are speculative.

My answer is that we pay the 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 anbd pitchforks catch up to them.

So we can either follow the example of Tim Geithner and Hank Paulson in AIG, paying out the CDS at face value, and embrace the Japanese model of economic stagnation for a decade.  Or we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into extinction.

I’ll be expanding on this happy them Monday.  Good weekend.

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