The Fed's new tactics

Get the bearish speculators. In the NY Times:

"Yet an effect of both deals, should they go through, is the elimination of all outstanding credit default swaps on both Bear Stearns and Countrywide bonds. Entities who wrote the insurance — and would have been required to pay out if the companies defaulted — are the big winners. They can breathe a sigh of relief, pocket the premiums they earned on the insurance and live to play another day.

Investors who bought credit insurance to hedge their Bear Stearns and Countrywide bonds will be happy to receive new debt obligations from the acquirers in exchange for their stakes. They are simply out the premiums they paid to buy the insurance.

On the other hand, the big losers here are those who bought the insurance to speculate against the fortunes of two troubled companies. That’s because the value of their insurance, which increased as the Bear and Countrywide bonds fell, has now collapsed as those bonds have risen to reflect their takeover by stronger banks.

We do not yet know who these speculators are, but hedge fund and proprietary trading desks on Wall Street are undoubtedly among them.

The derivatives market is huge, unregulated and opaque because participants undertake the transactions privately and don’t record them in a central market. The growth in the market and the potential for disruption, as a result of its size, has surely caused regulators to lose plenty of sleep.

Credit default swaps were created as innovative insurance contracts that bondholders could buy to hedge their exposure to the securities. Like a homeowner’s policy that insures against a flood or fire, the swaps are intended to cover losses to banks and bondholders when companies fail to pay their debts. The contracts typically last five years.

Recently, however, speculators have swamped the market, using the derivatives to bet on companies they view as troubled. That has helped the swaps become some of the fastest-growing contracts in the derivatives world. The value of the insurance outstanding stood at $43 trillion last June, according to the Bank for International Settlements. Two years earlier, that amount was $10.2 trillion.

But before a contract can pay out to a buyer of the insurance, a company must default on its bonds. In both the Countrywide and Bear Stearns takeovers, the companies were saved before they could default. Both deals also specify that the acquiring banks assume the debt of the target.

As a result, the insurance policies that once covered Bear Stearns and Countrywide bonds will become the obligations of much stronger issuers: JPMorgan and Bank of America. No payouts are coming, guys.

So consider all those swaggering hedge fund managers and Wall Street proprietary traders who recorded paper gains on their credit insurance bets as the prices of Bear and Countrywide bonds fell. Now they must reverse those gains as a result of the rescues. If they still hold the insurance contracts, they are up a creek — and the Fed just took away their paddles.

An interesting side note: It’s likely that JPMorgan, the biggest bank in the credit default swap market, had a good deal of this kind of exposure to Bear Stearns on its books. Absorbing Bear Stearns for a mere $250 million allows JPMorgan to eliminate that risk at a bargain-basement price. JPMorgan declined to comment on the size of its portfolio of credit default swaps.

We’ve yet to hear a peep about losses stemming from the Countrywide and Bear Stearns debacles. That doesn’t mean they aren’t there. Remember all those months that the subprime problem was supposed to have been “contained”?

IF we’ve learned anything from this year-long walk down the credit-crisis trail, it is that speculators on the losing end of such deals don’t typically volunteer that they have suffered enormous hits in their portfolios until they are forced to — often when they’re on the brink of collapse.

Do the Bear Stearns and Countrywide deals represent a regulatory template? Both had the same types of winners and losers. Bondholders won, while stockholders and credit insurance owners lost. Although there aren’t that many big banks left that are financially sound enough to buy out the next failure, it’s a pretty good bet that future rescues will look a lot like these.

Maybe it’s just a coincidence that both these deals involve wiping out billions of dollars worth of outstanding credit default swaps linked to Bear Stearns and Countrywide bonds.

Still, helping to trim the risk just a tad in the $43 trillion credit default swap market certainly qualifies as a side benefit. Had either Bear Stearns or Countrywide defaulted, the possibility that some of the parties couldn’t afford to pay what they owed to insurance holders posed a real risk to the entire financial system.

It’s pretty clear that some major losses are floating around out there on busted credit default swap positions. Investors in hedge funds whose managers have boasted recently about their astute swap bets would be wise to ask whether those gains are on paper or in hand. Hedge fund managers are paid on paper gains, after all, so the question is more than just rhetorical.

Losses, losses, who’s got the losses?"
http://www.nytimes.com/2008/03/23/business/23gret.html?ref=business