The Gordian Knot

The swift demise of American capitalism did not arrive as imagined by John Dos Passos—farmers with pitchforks linked shoulder-to-shoulder with the urban proletariat, marching on Wall Street to tear down the House of Morgan—but rather at the urgings of America’s leading financiers, who have cast aside their dog-eared copies of Atlas Shrugged and are now looking to the Government, with pleading in their eyes and fear in their hearts, in the hope that someone can clean up the mess and make things right again.

It is truly a Gordian Knot that Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are seeking to unravel, with threads that are interconnected and entangled.

Last Thursday evening, the two men met with leaders of Congress, and by all accounts left them speechless, as they described the cataclysm that might yet unfold. Though the meeting was not public, one can imagine how the presentation might have unfolded.

Paulson and Bernanke began by offering a timeline of events as the markets spiraled out of control—perhaps using AIG as Exhibit A. They described how the housing bubble, irresponsible lending and borrowing practices, and complex mortgage securitization structures led to the issuance of billions of dollars of securities that were vulnerable to a downturn. They explained how, as the housing market deteriorated, the mortgage-backed securities lost value and became illiquid. Under accounting mark-to-market rules established after the Enron collapse, the banks recognized these losses. As losses grew, the firms lost their capital reserves, their strong bond ratings, and their access to low-cost capital. Panic ensued. Banks and other financial institutions stopped lending as they moved to conserve cash. Short-term interest rates shot up in a matter of hours.

Almost overnight, the world lending markets dried up.

Paulson and Bernanke then pointed to two non-financial events that illustrated the public panic that would ensue if action were not taken to stanch the downward spiral.

The first event was the swift run on money market funds—nearly $90 billion withdrawn in one day—that came in the wake of the Fed’s decision not to bail out Lehman Brothers. Clearly, Paulson and Bernanke failed to anticipate the impact of a failure by Lehman on money market funds that invested in its commercial paper, and the run on money market funds that ensued after one fund, the Primary Fund, “broke the buck” and passed on its losses in Lehman paper to its money market fund investors.

The second event was contemporaneous run on AIG offices in Asia, where insurance policyholders frantically sought to cash in their policies prior to the looming collapse of the insurance giant. Facing public unrest, Asian central bank officials—who happen to be the largest holders of US Treasury securities—contacted Washington with some succinct advice: Fix it.

But as harsh as these real world examples are of the unraveling that might ensue if Paulson and Bernanke are not successful, there is a more troubling scenario that might have stunned Congressional leaders into silence. Perhaps, Paulson and Bernanke then turned to the problem that surfaced just as AIG teetered on the brink, before Paulson rushed in to buy the company last week.

AIG, like Lehman and Bear Stearns, is a major participant in the credit default swap market. The CDS market links buyers and sellers of corporate default risk, and offers the holders of corporate bonds the ability to sell the default risk associated with those bonds to a counter party. And as in most derivative contracts, credit terms are agreed to pursuant to which each party agrees to collateralize its obligations to the other party with Treasury securities, should its own credit be downgraded.

According to public accounts, just before the takeover, AIG had a collateral call on $60 billion of CDS contracts that required that the company immediately post $15 billion of Treasury securities as collateral, and anticipated a similar demand under a further $380 billion of its CDS contracts.

The $15 billion collateral call would have had an immediate impact on all of AIGs creditors and policyholders, as it would give the CDS counterparties a prior claim on those funds, putting their claims ahead of the range of other AIG creditors. A comparable collateral call on the other $380 billion of CDS contracts would have increased the aggregate collateral call to $100 billion, wiping out the company’s resources.

$100 billion of US Treasuries. That's 2% of the total volume of US Treasury securities. In the world.

What Paulson and Bernanke might have pointed out to the Congressional leadership, is that there are $62 trillion of CDS contracts currently outstanding—among American and international commercial banks, investment banks, hedge funds, pension funds and others. $62 trillion of uncharted obligations with attributes of debt to one party and a high-stakes gamble to the other.

$62 trillion. An amount greater that the $54 trillion gross domestic product of the entire world, as estimate by the World Bank.

On Sunday House Minority Leader John Boehner declined to describe the words that silenced Congressional leaders at the meeting, noting that there are certain things that you don’t discuss in public. Illiquidity in the banking system is something you can discuss. A run on money funds that was staunched you can discuss.

A universe of $62 trillion CDS contracts—defaults on which can send participants scrambling to seize collateral and protect their interests—derivative products whose terms and conditions are not subject to regulation or supervision—financial obligations once described by Warren Buffet as financial weapons of mass destruction—the impact of which no one really understands.

That is something you don’t talk about on the Sunday talk shows.

It is too much to grasp, really.