Who owns credit default swaps on GM? And who's on the hook?

Mortgage-backed securities and their derivatives were supposed to spread risk but ended up impeding mortgage restructurings as ownership of each mortgage split into anonymous fragments.

Credit default swaps were designed to offset lenders' risk but now may impede restructurings outside of bankruptcy, as some CDS holders have more to gain from the CDS payout triggered by default than they have to lose from default on bonds they hold . The FT's Henny Sender explains that holders of credit default swaps on General Motors' debt may derail the restructuring plan now on the table:

...analysts say the chances the proposal will be accepted have been diminished by the large number of credit default swap (CDS) contracts written on GM’s debt.

Holders of such swaps would be paid in the event of a default – but would lose money if they agreed to restructure GM’s debt. For investors who own bonds and CDS, this could create an incentive to favour a bankruptcy filing....

“Chrysler looks like a simple two-car funeral compared to the traffic jam of assets and liabilities and contracts at GM,” said the credit research boutique CreditSights.

Question: aren't something like 80% of credit default swaps held by "naked" buyers that hold no debt - that is, by those who are speculating rather than insuring? Sender reports that investors hold $34bn in CDS on GM's debt and would receive net payments of $2.4bn if GM defaults. How much of that is owned by bondholders, 10% of whom can derail the restructuring?

Question 2: who underwrote the bulk of that $34 billion in CDS? When GM teetered on the brink of bankruptcy last December, some warned that bankruptcy could trigger a financial chain reaction - specifically, via CDS. Could this be another chapter in the AIG crisis?

Postscript: Companies have already been pushed into bankruptcy by CDS holders. The Deal had this on 4/27:

Money Morning newsletter author Martin Hutchinson argued that swaps were catalysts for the bankruptcies of AbitibiBowater Inc. and General Growth Properties Inc.

AbitibiBowater could not persuade enough of its bondholders to exchange a portion of its $6.2 billion in debt and went into bankruptcy. General Growth, with $27.3 billion of debt, also filed for bankruptcy after bondholders refused to approve a restructuring. Subsequently, the value of a major tranche of General Growth bonds was determined by auction to be worth 71% of par, allowing investors to receive $710,000 for each $1 million in CDSs. "A nice reward for voting 'no' to a restructuring," Hutchinson wrote

Why the banks *held* toxic securities

John Gapper of the FT is proving himself to be eponymous (or rather the reverse -- whatever you call someone who's named for what he does). As the financial crisis has enfolded, he's emerged as a master at pinpointing the gaps in regulatory regimes that the banks have exploited.

Today he provides a primer in how the banks evaded capital requirements, why they loaded up on mortgage-backed securities, and how they rendered the 1988 Basel Accord (Basel I), which set capital adequacy standards for global banks, obsolete. Basel I, he recounts, set the minimum ratio of capital to assets at a conservative 8%, "but some investment banks entered this downturn with capital-to-asset ratios of 30 times or more." How did they pull that off? Gapper:

On assets, Basel introduced the notion of risk weighting, which essentially meant that some kinds of loans – for example, highly rated corporate bonds and, yes, residential mortgages – were considered less risky than others, so less capital needed to be held against them.

It was not a bad idea in principle but it set off two decades of financial engineering by banks to classify as many of their assets as possible as low-risk weighted in order to swell their balance sheets and so make a higher return on capital.

One of the puzzles of the financial crisis is why banks were caught with huge amounts of securitised mortgage debt when the point of securitisation – turning assets into securities – is to be able to sell loans.

Viewed through the Basel lens, however, the hoarding of securities made sense. By transforming 50 per cent risk-weighted mortgage loans into triple A securities, and with the help of rating agencies, banks reduced the amount of capital that they needed to hold against these assets.

That explains why the banks were not just packaging and selling toxic mortgage-backed securities for luscious fees, but holding these securities. And that was only step one in the metastasizing of leverage enabled by illusory risk management. Gapper again:

A bit of insurance wizardry took the regulatory arbitrage further. Banks could cut their capital charge to near zero by laying off the credit risk of mortgage securities to AIG through credit default swaps. Hey presto, billions of dollars of assets absorbing virtually no capital!

As the debt securities were illusory wealth, the CDS's proved to be illusory insurance. That's because they were not regulated as insurance -- CDS issuers were not under the jurisdiction of state insurance regulators, and so were not required to hold reserves to pay "claims," as payouts on credit defaults would be called if CDS's were true insurance. Quite a double-reverse the banks pulled off to get themselves past regulators and downfield into leverageland.

It has often been observed that as surely as bacteria adapt to antibiotics, human beings and the institutions they create will find the gaps in regulatory regimes. That's no reason to despair of regulation, though, any more than we abandon antibiotics. Regulatory reform must be ongoing as conditions change. And the best defense against corrupted regulatory reform is effective lobbying reform. Which in turn generates its own cycle of creative evasions. This cycle itself cannot be evaded.

Three circles of economic hell after a Big Three bankruptcy

As auto industry Armegeddon approaches, many are crying "let 'em eat coke." Let the Big Three go through bankruptcy hell and rise from the ashes, cleansed of their legacy labor costs, like the steel industry. Or keep on truckin' through bankruptcy, like the airlines.

Today, three separate sources brought home to me, in very different ways, the likely cataclysmic effects of auto industry failure.

1. On the Times op-ed page, former energy secretary Spencer Abraham argues that the airline and steel industry analogies are flawed. Bankrutpcy for an automaker will mean liquidation because

To purchase a car is to make a multiyear commitment: the buyer must have confidence that the manufacturer will survive to provide parts and service under warranty. With a declaration of bankruptcy, that confidence evaporates. Eighty percent of consumers would not even consider buying a car or truck from a bankrupt manufacturer, one recent survey indicates. So once a bankruptcy proceeding got started, the company’s revenue would plummet, leading it to hemorrhage cash to cover its high fixed costs.

No revenue means no DIP financing and no rebirth. Abraham ticks off the knock-on effects: a "cascade" of bankruptcies among parts makers, a squeeze on surviving automakers as suppliers fear to extend credit, liquidation of the Big 3, three million jobs gone in the first year, new burdens on government healthcare and pension guarantee services, enormous credit strains on banks holding auto loans.

2. Also into today's Times, Zachery Kouwe and Louise Story lay out the multiple levels of the financial sector's exposure to auto industry debt: $100 billion that the automakers owe directly to banks and bondholders; another $47 billion in loans to Big 3 affiliates backed by auto leases and loans; billions loaned to Cerberus in its leveraged buyout of Chrysler; untold billions more to parts suppliers, dealerships, and of course increasingly distressed consumers.

3. Finally, in today's FT, Wolfgang Munchau reminds us that in the wake of a big 3 bankruptcy credit default swaps would once again prove themselves, in Warren Buffet's phrase, financial weapons of mass destruction:

Naturally, [a carmaker bankruptcy] would be bad for the US car industry itself. But it might be even worse for the banks, especially those that got involved with credit default swaps – probably the most dangerous financial products ever invented. CDSs are unregulated shadow insurance products that investors buy to protect themselves against default of corporate and sovereign bonds. Protection against a default by General Motors was among the most sought-after contracts.

Some have called for a "managed bankruptcy." Looks to me like a managed bailout, with all stakeholders giving up something in advance, would be a lot less risky.