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Behind counterparty risk and credit default swaps (why AIG was rescued)
Globe and Mail ^ | September 16 | Staff

Posted on 09/16/2008 9:41:11 PM PDT by PghBaldy

. What is counterparty risk, and why is it suddenly an issue? In the simplest terms, counterparty risk is the chance that the person on the other side of a deal - the counterparty - won't be there when it's time to pay up. Take an example most people can relate to: Selling a home. There's always the chance that when it comes time to close the deal a month or so down the road, the buyer won't show up or won't have the money. In financial markets, traders and banks are constantly thinking about counterparty risk. When they make a deal to buy or sell, they often look at the credit rating of the party on the other side of the transaction. If the credit rating is high, they will go ahead with the deal. If the credit rating isn't so hot, they might ask for additional guarantees or collateral. Or maybe they won't do business with the counterparty at all, which is what happened to Lehman Brothers and Bear Stearns in their last days. How does that relate to what's happening at AIG.? As an insurer, AIG expanded into the business of selling insurance against bond defaults, probably figuring it wasn't that much different than writing life or home insurance. AIG provided the insurance through derivative contracts known as credit default swaps. The problem for AIG is that it looks like there could be a lot of claims at once because of a wave of defaults on mortgages and by companies such as Lehman Brothers, Fannie Mae and Freddie Mac. By some estimates, the firm could face losses of $25-billion (U.S.) on the swaps.

(Excerpt) Read more at theglobeandmail.com ...


TOPICS: Business/Economy; News/Current Events
KEYWORDS: aig; cds; derivatives; economy; govwatch; housingbubble; swaps
This is why the govt felt the need to bail them out, IMO. It would supposedly have caused a chain reaction of VERY large size.
1 posted on 09/16/2008 9:41:12 PM PDT by PghBaldy
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To: PghBaldy

bookmark


2 posted on 09/16/2008 9:43:12 PM PDT by GOP Poet
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To: PghBaldy

That might not be a big enough dam for this river... You hear about the Russian Markets??? Yea, take a look at that and wonder.... http://www.ft.com/cms/s/0/6ff9306c-83f1-11dd-bf00-000077b07658.html


3 posted on 09/16/2008 9:44:27 PM PDT by Danae (Read my Lipstick: I AM Sarah Palin)
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To: PghBaldy

bm for later


4 posted on 09/16/2008 9:44:59 PM PDT by downwdims
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To: PghBaldy

I guess this is why I’ll never understand high finance - AIG’s supposedly got 1.3 trillion in assets, it just seems like 25 billion is the change left in the couch.


5 posted on 09/16/2008 9:45:28 PM PDT by kingu (Party for rent - conservative opinions not required.)
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To: PghBaldy

Meh. I guess I’m old fashioned, but I always thought the economy was best left alone, both from regulation and corporate welfare.


6 posted on 09/16/2008 9:46:17 PM PDT by TheWasteLand
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To: PghBaldy

There is so much damn insolvency in the financial world, it makes one’s head spin. Is there one enterprise that wouldn’t fail if everyone demanded their money at the same time?


7 posted on 09/16/2008 9:50:01 PM PDT by Tublecane
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To: PghBaldy

Since they recently bought 21st Century insurance I think we had better be locking for a new auto insurance company.

Since the banks are the majority of the voting members of the Federal Reserve they just voted to cover their backsides and stick it to the US citizens.


8 posted on 09/16/2008 9:51:51 PM PDT by dalereed
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To: PghBaldy

Strangely enough, I believe no matter what the govt does, there will be massive financial disaster. As it is, with the derivatives, which Warren Buffet (whose love of high taxes and Obama I strongly disagree with...) considers weapons of financial destruction (or words to that effect) I’m afraid eventually they will blow up. I also believe the financial world as a whole has been too careless in assuming their computer models can protect them by modeling the future. This period we are in HAS NOT been planned for by many of our best and brightest. No coincidence that the last crisis of similar complexity occurred before most of this wizards were born.


9 posted on 09/16/2008 9:58:10 PM PDT by PghBaldy (Obama: Terror Groups have "legitimate claims.")
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To: PghBaldy

WHICH ABSOLUTELY NEEDS TO HAPPEN TO CLEAN UP THE MESS!!!

ALL THE GOVERNMENT IS DOING IS FORSTALLING THE INEVITABLE AND MAKING THE RESULTING MESS THAT WILL COME EVEN BIGGER!!

Yep, letting these financial companies fail will be like dominoes, because so many of them are on rediculously shaky ground... however it needs to happen, and trying to prevent that pain, will only draw it out longer and make it worse in the long run.

The Piper’s going to be paid, and hopefull the folks behind it will be brought to justice, but since the Countrywide CEO could pump and dump $1/2 a billion with impunity, I won’t be holding my breath.

Shakespeare had it wrong, first you kill all the investment bankers.


10 posted on 09/16/2008 10:11:49 PM PDT by HamiltonJay
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To: kingu

hahahaha.. not when 1.3 Trillion in assets is mostly paper assets that no one can even effectively value.

Paper wealth disappears as quickly as it appears, nice ride when it goes up, sucks eggs when it goes down. If you don’t have real money in your hand, you don’t have squat.


11 posted on 09/16/2008 10:13:34 PM PDT by HamiltonJay
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To: TheWasteLand

Welcome to Socialism.


12 posted on 09/16/2008 10:25:16 PM PDT by trumandogz
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To: PghBaldy

I’ve got life insurance with those guys, so now my life is insured by the Federal Government. Don’t touch me!

At the rate of bailouts, I am not sure I am trading up by much.


13 posted on 09/16/2008 10:51:53 PM PDT by Roy Tucker ("You can avoid reality, but you cannot avoid the consequences of avoiding reality."--Ayn Rand)
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To: trumandogz

Welcome to Oligarchy is more like it.


14 posted on 09/16/2008 10:58:30 PM PDT by skipper18
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To: PghBaldy

Look out below (kiss the good life goodbye) - an estimated $600 trillion of derivative, “counter party,” obligations to be set off in a chain reaction reminiscent of the big old bomb.


15 posted on 09/16/2008 11:51:57 PM PDT by GregoryFul
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To: HamiltonJay

“Shakespeare had it wrong, first you kill all the investment bankers.”

lol at the time that was the nobility I would think, so maybe lawyers were as close as he could come to that part of the social pyramid without creating notable problems for himself?


16 posted on 09/17/2008 12:22:32 AM PDT by WoofDog123
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To: TheWasteLand

counter-party risk is weird, with regard to your very reasonable philosophy. I think that, once you exist in a world where a system of trade settlement and clearance exists such as today, you are no longer able to suggest such a system as a viable option within those conditions.

Basically, the financial markets operate with the implicit understanding that the firm you are doing trades with today will be around later today, or in 1 or 3 or possibly 30+ days to settle the trade you do today. Literally, as long as all the paperwork is done, trade settlement is a ‘back-office’ issue, and one that never demands attention. Between today and the day the trade formally settles, you may have sold the bonds or stock you bought. The risk that your purchase will not properly settle due to the other side (counterparty) not meeting their delivery obligation is called counterparty risk. Imagine, a few days after doing a trade in XYZ stock, being called upand being toldyou were being DK’ed in your purchase of the stock (which you sold a bit later), yet the stock is up 20% since then. There is a huge loss on the books, yet who is responsible (aside from the firm that you did the trade with, who is presumably bankrupt)?

Who pays? A large trade will take your entire FIRM under with that kind of loss%.

A failure of the scale of Bear or AIG would create such a potential spaghetti of counter-party risk that additional, unrelated complications in our financial system would result as a direct consequence.

If you want a financial system free from both corpwelf and regulation, you might refer to systems in place pre-20th century, at least as an index, since i don’t think anything short of hard-currency or barter is free of regulation. You will be functioning on a letter-of-credit and hard-currency basis. 20th century medicine may be unobtainable, given the mass capital needs of producing it. Grain, coffee, tea, pork bellies, will need to be paid for in hard cash by an agent in each market city.


17 posted on 09/17/2008 12:39:30 AM PDT by WoofDog123
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To: PghBaldy
Counterparty risk and swaps appear to be nothing more than an attempt to inflate the bottom line of financial institutions. And when it all fails they just stick it to the little guys (us).AWB
18 posted on 09/17/2008 1:50:47 AM PDT by Americanwolfsbrother (I've forgotten what its like to watch the Packers without Brett Favre....)
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To: PghBaldy

Well we taxpayers are out another 85 billion bucks and the futures are still showing -140 this morning.

LET THEM DIE


19 posted on 09/17/2008 5:46:52 AM PDT by TomasUSMC ( FIGHT LIKE WW2, FINISH LIKE WW2. FIGHT LIKE NAM, FINISH LIKE NAM)
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To: PghBaldy

Seems pretty straightforward. If these liability policies are deemed worthless you can watch the Great Depression unfold before your very eyes. AIG is a partner to almost every refinery transaction that takes place. You want in the refinery to do work? Provide insurance. No insurance, no access. No access, no products and services. The chain reaction could have been something to behold.


20 posted on 09/17/2008 8:22:50 AM PDT by kinghorse (Unhunkered. Ike is teaching people about local self reliance. FEMA is not your nanny.)
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This AIG bailout is a warning and gives businesses time to figure out how to insure their risk another way. I see it as buying time, nothing else. If it just failed, we would have seen chaos on an unmatched level and business seizing up. This bailout is a lot like FEMA. It buys time for the people to recover from a shock.

My tagline says FEMA isn’t a nanny but if you took away all support overnight, without first giving people a taste of the discomfort of a disaster and allowing them to transition to self reliance, it would be chaos. Murder and mayhem in the streets. The government buys time during a crisis. Seems somewhat reasonable.


21 posted on 09/17/2008 8:29:43 AM PDT by kinghorse (Unhunkered. Ike is teaching people about local self reliance. FEMA is not your nanny.)
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To: PghBaldy

They don’t know what the dose of poison in the system is now. They have no idea. How can I say that? Hunch, based on observations of the public reports. Look at Warren Buffett’s Berkshire experience in trying to digest an earlier take-over of a huge re-insurer: General Re. It took *years* for Buffett’s team to understand, value and unwind the derivatives contracts.


22 posted on 09/17/2008 8:30:02 AM PDT by bvw
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To: PghBaldy

$62 Trillion in CDSs like those that sunk AIG and some morons here still think derivatives are a zero sum game that will just cause Jack to have to pay Joe and not vaporize the entire RIRE economy. Right... That’s why the largest insurer just went tits up. Zero sum... Yeah... Right... Morons.

Yes, I know AIG was illiquid, not insolvent. Tell that to the company holding your $1 million house mortgage. “But my house has $950,000 in equity. I only lost my job and now I can’t pay you on that million but I’m only upside down by $50,000.” Sorry pal. Bye, bye house...

Derivatives. Zero sum game. Morons.


23 posted on 09/17/2008 8:44:29 PM PDT by Freedom_Is_Not_Free
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To: kingu

Lets say you live on your $5 million dollar yacht you inherited, but you are dirt broke right now. You need $5,000 for rent for your slip in the marina until your friend pays the $10,000 he owes you. So you go to a Mafia loan shark and he gives you the $5,000 but you owe the $10,000 next month.

Next month, you call on your friend and learn he died in a car accident. The Mafia loan shark comes for his $10,000. Now, he tells you either he breaks both your kneecaps and burns your boat to the waterline, or you can sign that $5 million yacht over to him.

Would you give him the boat? I mean, $10,000 is just the change left in the couch of your $5 million yacht, right?

Same principal. You can have all the money in the world tied up in assets you can’t sell very fast but they don’t do you a damn bit of good the day you need cash on the barrel head.


24 posted on 09/17/2008 8:54:24 PM PDT by Freedom_Is_Not_Free
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To: PghBaldy

” I also believe the financial world as a whole has been too careless in assuming their computer models can protect them by modeling the future. “

The computer models are based on the fact that black swans don’t exist. Everything works perfectly until a black swan shows up.


25 posted on 09/17/2008 10:04:09 PM PDT by Pelham ("Borders? We don' need no stinking borders!!")
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