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Splat: Where does the number 700 come from? I'm afraid to guess, but here it is.

We know from a slip of JPM CEO Dimon's tongue that the cost of the Bear Stearns mugging was $600 Billion! That figure appears nowhere else, but it does explain why the FED's balance sheet is trash and they need to manufacture new T-Bills to shore up the FED. New T-Bills, in turn, require yet another increase in the debt limit. This assumes, of course, that they are half honest over there, a big assumption.

We also know at least in times of stress the approach is to act now and catch up with remedial legislation to make legal what's already been done. The lady gets to put her robes back on and be an honest woman. That's High Finance. Always has been, even when my Dad worked on the periphery of that world.

So, I wonder. Is the whole 700 for AIG? Paulson wants complete discretion and no disclosure.

I know. The numbers boggle the mind. But consider. The characterization of credit derivatives as insurance seems relatively benign, and is misleading. They have some peculiar characteristics.

First, both parties book a profit immediately. In your world and mine one has to be lying. In the Fairy Tale World of High Finance these are contracts with which everyone is a winner! The Princess gets two handsome husbands by kissing just one frog! Mutual profitability is one reason all the major companies used them to "smooth" those marvelous earnings that kept beating expectations by a penny a quarter for years on end. No wonder everyone wanted to be a party or a counter party. "Win Win" takes on new meaning.

Second, the underlying disaster has nothing to do with the total of outstanding derivatives that provide the "insurance." When Delco went down the derivatives written against a default of Delco bonds exceeded the total of Delco bonds outstanding, and exceeded the total by orders of magnitude. These are pure speculative bets, and the game is more lucrative than the games in Las Vegas. You get to book profits as you go. You don't even need to hold the actual bonds. Heck, that means you get the handsome princes and don't need to bother with a frog at all! There are fees all around, for the lawyers, for the bankers, for the cascading "reinsurers" who become counter-parties down a daisy chain for smaller fees, and so forth. While the music played no one worried about balance sheets or ability to perform. No one worried about financial STD. Those dinners at Delmonico's were scrumptious.

Third, there are two different values for each contract. The first is "mark to computer program" book value, not "mark to market" because there is no market and never has been one. That's what "hard to value" and Level 3 assets mean. Listen carefully to all those experts telling you how they are going to solve the problem. Invariably they want the new "mark to market" rules suspended. Here's why:

When Merrill touched off the insolvency crisis by grabbing collateral from two Bear Hedge Funds and actually, horror of horrors, trying to sell it they discovered the bids dropped quickly, first to 40%, then to 10%, then to ZIP, of that book value. Voila. Every bank was insolvent. Someone at Merrill got confused and tried to live the Fairy Tale in real life.

Which brings us to the second value, "notional" value. What makes these contracts WMD's is not the fact that there is no market. No market merely is the TNT, the bunker buster. Once the bunker is busted one counter-party fails. That in turn, places a real "performance value" loss on the balance sheet of the other, momentarily surviving party. Don't ask me why this is. I don't fully understand, but Sinclair says that's the way it works and he's more experienced and closer to the nuclear core than am I. It's on the balance sheet. It's got to get off. It can't get off without a BOOM at the value of performance nominally expected no longer possible. This means that a default by Delco of, say 100 Million, triggers leveraged (50 to 1) performance requirements for, say 5 Billion, and if as a result another counter-party fails that triggers leveraged performance requirements on all the outstanding contracts to which it is a party, and on down the line.

This would explain Dimon's 600 Billion figure for the cleanup of Bear. It explains why no one understands the numbers. It explains why Lehman going down triggered AIG going down. It explains why the numbers AIG needed initially gyrated all over the place. And it would put a figure of 700 Billion just for AIG in the ballpark.

And all of this assumes that there are some underlying assets somewhere, an assumption that is in doubt at least as far as the fantasy collateral underlying Fannie and Freddie guarantees is concerned. (That's a scandal not yet in the public consciousness.)


Paulson must be feeling very helpless for a kid who for years optimistically tossed horse manure in the air looking for a pony, only to find himself in those famous Augean Stables, looking in vain for Hercules. http://en.wikipedia.org/wiki/Augeas

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