CDS typically have mechanisms whereby the CDS underwriter may need to post collateral to guarantee its obligations: this is what brought AIG down: as signs of trouble started to build, it lost its AAA-rating, which triggered obligations to pay collateral to all its counterparties on its portfolio of CDSs. It is those obligations, all coming at the same time on a large pile of CDSs, that bankrupted it and led government to step in to make the necessary payments.
Note that initially, the government did not even use taxpayer money to make actual payments under the CDSs - just to post collateral. Now, as CDSs are triggered, full payments need to be made, thus the successive bailouts.
The justification for these bailouts is that not paying out on these CDSs could make some of the buyers of protection bankrupt themselves, thus triggering more CDS payments, giving birth to further liabilities for the institutions that underwrote the CDSs. In addition, givne that many of the buyers of CDS protection were banks or hedge funds, there is worry of a domino effect.
It is that liability crash which is the cause of the continued lack of trust in financial institutions by the markets themselves: they know that financial bombs are littered all over the landscape.
Buying toxic assets is "nice" for banks, but solves nothing. Bailing out AIG, oddly enough, could be seen at least as a step in the right direction - the problem of course being that if you're going to take care of all potential liabilities, the total bill might be in tens of trillions, rather than mere trillions - with a lot of that money going to the smart hedge funds that bet on things going badly in various markets and for various institutions (cf Pauslon above).
Given all that, we have several routes:
- one that gives a lot of money to banks that do not deserve it to solve their asset problem, but still do not make them creditworthy (the current Geithner plan), which gives stock markets a temporary boost, taxpayers permanent pain, and solves nothing;
- one that does help them get rid of their real problem (huge contingent liabilities on bets that are turning sour), but is vastly more expensive than the mind-numbing numbers we're throwing around already, and gives all the money to hedgies: the AIG route, multiplied ten or hundred-fold;
- one that acknowledges that the issue is liabilities rather than assets, and that focuses on the fact that a lot of these liabilities are wholy unrelated to any economic or financial activity, and are contingent rather than actual - ie nobody loses anything if they are cancelled. If a 100:1 bet you made is cancelled, your actual loss is not 100, it is 1 - something that could be paid back to you.
So far, the second route has been used when an emergency beckoned (AIG et al); the first route has been used massively but the Treasury does not seem tired of it yet, and the third one seems anathema.
Of course, it means taking the shiny toy away from the hands of the hedgie kids.
Why is that a bad thing, again?
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