Orwellian Nationalization: ‘no plan’ for Credit Default Swaps

February 26, 2009

Today, regarding GM, Reuter’s reports:


GM posted a deeper-than-expected quarterly loss as revenue plunged by more than a third.  The automaker warned its pension plans for hourly and salaried workers were underfunded by about $12.4 billion as of the end of 2008.


The company, which has been kept afloat with emergency loans from the U.S. government since the start of the year, posted a net loss of $30.9 billion for 2008.  That ranked as the second largest annual loss for the 100-year-old automaker on record behind only the $38.7 billion loss recorded in 2007.


GM has asked for a total of up to $30 billion in total aid from the U.S. government to survive a plunge in sales in the global auto market.


GMs senior management team and board of directors remain in place.


Today, regarding Citigroup, Fox business news reports:


Citigroup Inc.’s bid to boost its equity capital could result in the federal government raising its stake in the troubled bank this week to as much as 40 percent…


Citigroup has already received $45 billion in U.S. bailout money made up primarily of debt-like preferred shares, plus federal guarantees to cover losses on some $300 billion in risky investments.


Citigroup’s senior management team and board of directors remain in place.


Today, regarding AIG, the Financial times reports:


AIG and the US authorities are in advanced discussions over a radical restructuring that would split the stricken insurer into at least three government-controlled division in an attempt to keep it afloat…


Under the plan, the government would swap its current 80 per cent holding in the insurer for larger stakes in three units…


However, people close to the situation said AIG was on track to… report a $60 billion loss with its fourth-quarter results.


AIG’s senior management team and board of directors remain in place.


All of this begs the question – what is the difference between pumping hundreds of billions of dollars in taxpayer money into these companies and simply nationalizing them?  There are two differences, and each one is bad news for the taxpayer. 


The first difference is that, under the current plan, directors and management continue to earn compensation, set strategy and execute tactics.  The taxpayer, through the federal government, is on the hook for the money, but has no direct say in how the company is run.  The main difference, however, has to do with controlling interest and credit default swaps.


Controlling interest and credit default swaps


First, let’s look at GM.  I quote an observation made on this site on January 21st:


Here is the real story, the one you won’t hear on the news:

As you now know, after weeks of downplaying the issue, Treasury, a few days before the bailout was finalized, hinted it may actually be willing to use TARP funds to fund a short-term bail-out for the Big Three. You may ask yourself why the reversal.

If you remember, GM brought in the BK attorneys about a week before ‘to consult’. This move was aimed at squarely at the capital markets: GM has roughly $1 trillion in outstanding credit default swaps.

There are tens of trillions in unresolved CDS out there. The problem of unwinding these swaps in the absence of a CDS exchange (to monitor liquidity or carry out liquidations to cover positions) is at the heart of this financial crisis. As many of the original readers (pre-wordpress) remember me saying over a year ago, this crisis has little to do with mortgages. This is a capital markets crisis.

This is why reorganization through a BK court has not seriously been entertained.

If a BK court was allowed to resolve credit default swaps, it would rattle the financial markets beyond the control of the central banks. The decisions of the BK court would set precedent that could then be used to challenge CDS agreements in court. Further, these precedents would stand in other BK proceedings (think Lehman) and major financial institutions (already functionally insolvent) would collapse.

Next, let’s look at Citi and AIG, both the insurers and the insured, of hundreds of billions of dollars in notional credit default swaps.  The reason why this pseudo-nationalization is occurring (all of the exposure of nationalization without the controlling interest) is that nationalizing a bank or major financial corporation would create a ‘credit event’, or event of default, that would trigger payouts of debt insurance contracts beyond any insurer’s capacity to pay.  In the absence of an exchange to manage the unwinding of CDS contracts and liquidate insolvent market participants, there is simply no way to unwind the mess – in other words, complete seizure and potential collapse of the global ‘FIRE’ economy (finance, insurance, real estate) that is central to the central-banking, fiat money, fractional reserve lending, modern state-controlled economy.


Therefore, as if nationalization weren’t bad enough, we now have Orwellian Nationalization: the taxpayer is on the hook for the bad debt, but the same geniuses are still running the show – at GM, at AIG, at Citi, at Bank of America, et. al.


There are essentially three options for dealing with insolvent financial firms.


1. Bankruptcy and liquidation: this is the only effective solution, one for which ample precedent already exists and the only one I favor.  Under this scenario, insolvent financial firms simply go out of business.  Equity holders are wiped out (the ‘risk’ portion of the risk/reward stock market dynamic).  The company is broken up and assets of any value are sold to pay creditors.  Stronger firms may opt to purchase pieces of the broken-up, bankrupt organization and often get good deals on segments that still have value.


2. Nationalization: this is final and decisive act by government and includes variations such the creation of a ‘bad bank’ model.  In a pure nationalization, government may directly run the nationalized firms as ‘government banks’ – look for these types of solutions in Europe as the crisis worsens.  Another variation is the ‘bad bank’ model, such as the Resolution Trust Corporation the federal government employed during the S&L crisis.  In this variation, insolvent financial firms are taken over by the government and assets are split: performing assets are sold off to liquid competitors, while the illiquid assets are maintained in a government-run holding company and slowly liquidated.  Direct nationalization is a disaster as government has neither the expertise nor managerial ability to effectively run a large, global bank.  The ‘good bank/bad bank’ scenario would be a disaster due to the sheer dollars involved and the lack of oversight on the trillions of dollars spent so far.  What typically happens is that investors, creditors and senior management own the good bank.  You, the tax payer, end up owning the bad bank.  Naturally, investors, creditors and senior executives favor this solution.


3.  Orwellian Nationalization: in an effort to kick the CDS can down the road, this is what we have today.  The way this works is that government guarantees the bad debt of insolvent financial institutions ad infinitum.  First, hundreds of billions of dollars are pumped into these firms.  When this ‘investment’ by government changes nothing, hundreds of billions more dollars are fed into the meat grinder.  Soon, billions turn into trillions.  And the status quo remains – insolvent institutions with hundreds of billions in non-performing tier 3 assets remain insolvent.  Unfortunately, a new, perverse dynamic is created.  Capital flows to where it perceives it is most protected.  With implicit government guarantees turning explicit by the day, investors abandon good, solvent banks in favor of government-guaranteed banks.  Why not?  Why take the risk with a free-standing, private bank when you can invest in one that is backed by the printing press of the federal reserve?  In this manner is perverse incentive laid upon perverse incentive.


The important thing to remember here, as frequent readers know, is that the federal government does not have any money.  The only money the federal government can spend is that which is confiscated from productive citizens in the various forms of overt taxation, or that which it can borrow.  The interest on that borrowed money is inflation – the covert tax on every private, fiat dollar earned or owned, in perpetuity.


And so George Orwell would be proud.  Bernanke has “no plans” to nationalize insolvent American banks.  There is much truth to this statement.  While insolvent banks will eventually be nationalized, it is true that Bernanke has ‘no plan’ on how to do this without triggering uncontrollable events in the international, state-controlled, fractional reserve, fiat money economy.







6 Responses to “Orwellian Nationalization: ‘no plan’ for Credit Default Swaps”

  1. Nick Says:

    Your argument is completely untrue, because CDS are exempt from the automatic stay of bankruptcy. Bankruptcy courts have no authority whatsoever to “resolve credit default swaps.” Sorry to burst your bubble, but your entire argument is based on a premise that is 100% false. I guess you’ll have to come up with a new conspiracy theory now.

  2. Nick- for the record, one of my explanations for the current quasi-nationalization regards the problems of bankruptcy court. The other involves the event of default relative to overt nationalization.

    I am not sure where you are getting your facts, but in bankruptcy court, a companies owned CDS contracts are part of its total assets and liabilities. Further, CDS written on the bankrupt companies debt pose a tremendous challenge as a bankruptcy filing is an event of default. A US bankruptcy judge has limited legal ability to enforce or affect CDS contracts that may be held by foreign corporations, foreign individuals or even foreign governments. This is precisely the problem – and it’s the reason why an ‘orderly bankruptcy’ is not an option. Hence my comment that attempting to ‘unwind’ hundreds of billions of dollars of CDS in bankruptcy court would be a disaster.

    As for my “coming up with… conspiracy theories”, I’ll let my readers be the judge. The sources I cite are mainstream. The issues I reference have enormous impacts on the lives of every American.

    Evidently, you feel comfortable with the current state of affairs. I suggest that many others are not.

  3. Nick Says:

    I’m getting my facts from the U.S. bankruptcy code:

    11 U.S.C. 362(b)(17). Automatic Stay — The filing of a petition under section 301, 302, or 303 of this title … does not operate as a stay … of the exercise by a swap participant or financial participant of any contractual right (as defined in section 560) under any security agreement or arrangement or other credit enhancement forming a part of or related to any swap agreement, or of any contractual right (as defined in section 560) to offset or net out any termination value, payment amount, or other transfer obligation arising under or in connection with 1 or more such agreements, including any master agreement for such agreements.” [emphasis mine]

    Where are you getting your facts?

    Also, overt nationalization would almost certainly not be a “credit event” triggering payment on CDS contracts. Nationalization would be accomplished by the government taking a majority stake in the bank — that is, buying common stock. That’s what nationalization is. CDS reference a company’s debt, not its equity. A credit event occurs when the reference entity files for bankruptcy or fails to make timely payment on its bonds.

    AIG has effectively been nationalized (the government owns warrants representing 80% of AIG’s equity), but there has been no credit event on CDS written on AIG. Similarly, the UK government has nationalized Lloyds and RBS, but there was no credit event for those companies. The only way nationalization would be a credit event is if the government puts the banks in a formal receivership (highly unlikely), or if the government forces senior bondholders to take a haircut (since the vast majority of CDS reference senior debt), which is also highly unlikely.

    I never said that I’m “comfortable with the current state of affairs,” or that the issue of nationalization doesn’t have an enormous impact on the lives of Americans. But if you’re going to write about such an important issue, you should probably make sure you get the basic facts right.

  4. And with that well-written comment you have proved my point – the INABILITY of a bankruptcy court to unwind or nulify CDS contracts would ignite an international CDS crisis by triggering payments between third parties holding CDS on the debt of companies in bankruptcy. The fed wants to avoid this outcome if at all possible – hence, no bk for companies that should be in bk.

    In your rush to disprove what I’m saying, I fear you have overlooked what I’m saying.

    Regarding your 2nd point – AIG has absolutely NOT been nationalized. Taxpayers have a ‘stake’ in AIG, but no operational control. The distinction between ‘nationalization’ and ‘receivership’ simply obfuscates the issues involved. Under the current model, taxpayers are no different that individual common stockholders, other than the fact that common stockholders can at least throw in the towel and sell.

    If you are uncomfortable as I am with the state of affairs, share your solution.

  5. This just in:

    “President Barack Obama penciled into his budget on Thursday the possibility that he may request an additional $250 billion to help fix the troubled U.S. financial system.

    Any additional request to Congress would come on top of the $700 billion financial bailout program enacted last year to deal with the overhang of toxic mortgage debt that is hindering banks’ ability to lend and worsening the recession.”

  6. More on AIG CDS:


    AIG Rescue May Include Credit-Default Swap Backstop (Bloomberg)

    Regulators who saved AIG in September feared that a collapse of the insurer, which sold swaps to banks including Goldman Sachs Group Inc., would spread losses throughout the global financial system. In November the U.S. committed $30 billion to retire some of the contracts tied to subprime mortgages, while not addressing other swaps tied to corporate loans and European debt.

    “Counterparties around the world continue to have significant exposure to AIG, and market conditions continue to be fragile and sensitive to the potential disorderly failure of AIG,” the Federal Reserve said in a report in November.

    AIG provided protection on more than $300 billion of assets through credit derivatives as of Sept. 30. Credit-default swaps pay the buyer face value on their debt holdings in exchange for the underlying securities if the borrower fails to meet its obligations. It wasn’t immediately clear how many of the swaps would be backed by the U.S., and talks are continuing, the person said.

    AIG has posted four straight quarterly losses on swaps tied to U.S. home loans.

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