Obama has walked into a trap with the selection of Timothy Geithner as Secretary of the Treasury. Chris Whalen, certainly no enemy of the financial markets, has written a strongly worded warning in Nouriel Roubini’s RGE Monitor, What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup.
Whalen’s warning has been picked up by Barry Ritholtz, and by William Grieder.
While Geithner was blind-sided by the financial meltdown, Whalen, Roubini, Ritholtz, and Grieder all were warning, years ago, of a housing bubble pregnant with financial catastrophe.
Whalen’s warning is not an easy read, so I’ll try and distill it for you before presenting some excerpts.
Whalen is head of Institutional Risk Analytics, a bank monitoring firm that Grieder notes "has repeatedly been right about the banks when the government officials were wrong" [including Bush, Bernanke, Paulson, and Geithner]. He notes that the hundreds of billions of dollars dumped into AIG by the Fed and the Treasury have gone to pay off, at face value the credit default swap contracts (CDS) written by AIG to insure against default of collateralized debt obligations (CDOs), such as the sub-prime mortgage derivatives that initiated these crises last year. Now that hundreds of billions in CDOs have defaulted, AIG has to pay out tens of billions on the CDS it sold.
"So what?" you might be asking. Well, the thing is, as Devilstower explained here, credit-default swaps developed into mere gambling bets, with neither regulatory oversight nor proper margin requirements.
Even worse, as stephdray explained in Paulson can't buy toxic mortgages, b/c they don't exist, CDS were written on thin air, as purely speculative bets.
The amount of CDS written are in the tens of trillions – many times larger than the entire U.S. economy. Whalen points out that even using very conservative estimates, the amount that needs to be paid out on exploding CDS is $15 trillion.
And it’s all going to the worst part of Wall Street, the gamblers.
This is why, as SusanG headlined on the front page today, The new price tag being bandied around: $7.4 trillion.
Wait, it gets even more interesting. Whalen notes that the gamblers have taken out trillions of dollars in CDS to bet on the failure of the U.S. automakers and the companies that supply them. If GM is allowed to go bankrupt, it will spark a flash fire of CDS claims that are simply unpayable because of how huge they are.
All this has been done while Geithner was President of the Federal Reserve Bank of New York.
And the position Paulson, Bernanke, and Geithner have taken thus far – presumably the position Geithner will advocate for when he is Obama’s Treasury Secretary – is the gamblers’ bets must, and will, be paid off.
Remember folks, we are talking about some $15 trillion in CDS payouts here. That’s the size of the entire U.S. economy.
How can anyone possibly find words to convey the sheer insanity of the idea that the most important thing is to pay off the f#@king gamblers?!
Yet, even more amazement - somehow, someway, there are not bands of outraged citizens roaming lower Manhattan at this moment, chasing down, beating, and hanging every suit in sight.
No wonder the stock markets are giddy with glee on news about Geithner’s appointment. The markets are being told loud and clear that their fun and games will continue under Obama.
And we’ll pick up the check.
What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup
Chris Whalen
November 24, 2008
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, has 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 unfunded obligations 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’s CDS 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, somebody like Fannie Mae CEO Herb Allison. 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.
SNIP
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 Tim Geithner.
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 mess before 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. 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. 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.
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 debt... 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."