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 ...
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.
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.
$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.
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.
” 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.
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