Defaulting banks - where will it stop?

[Jan Klimkowski]

Insider market chatter:

We hear from a very well placed Buy Side investor with extensive business interests in the US and EU that three primary banking institutions in Europe, two French and one German, have such significant CDS exposure and other problems that they cannot even begin to fund the payouts anticipated over the next quarter.

The funding squeeze reportedly is exacerbated by a near-collapse among weaker players in the hedge fund market, who were accustomed to receiving loans from one large French institution, which then stupidly converted the loans into equity. That's right. This past summer, when the bank put out a call for redemptions of $4 billion in hedge fund investments, says the source, only $400 million was returned. And the French bank also used these same hedge funds and others to reinsure some of its own CDS exposure. Sound familiar? Yup, just like AIG.

Unlike the approach taken by Paulson and Geithner to bailout AIG and JPM (via the Bear Stearns rescue), however, the investor claims that EU officials are considering a moratorium on CDS payments by the three Euroland banks in question. The banks would be given ten years to write down their CDS and hedge fund exposures and would receive additional infusions of capital by their respective governments. The source claims that French banks have such huge exposure to both hedge funds and CDS, sometimes linked together, that the positions are beyond the ability of the EU governments to bail them out without a cessation of CDS payments.

The IRA was not able to obtain a comment from EU officials over the weekend about these allegations. We'll be making some calls Sunday night and Monday. But if this unconfirmed report turns out the be true, then the beginning of the end of the CDS market as we have known it will be at hand. And ironically, the catalyst for the final solution will come not from the failure of a US dealer, but instead by a moratorium on CDS payments by an EU bank.

In the event, as other governments around the world follow the very reasonable example of the EU, the OTC derivatives market will implode and these unfunded liabilities may very well force the nationalization/liquidation of C, JPM and AIG, among others. And in the event, Hank Paulson, Tim Geithner, Alan Greenspan, Ben Bernanke and other senior officials at the Fed in Washington are going to have a lot of explaining to do to the Congress, to a new President and the global financial community.

Tell us again, Chairman Greenspan and Chairman Bernanke, just why do you believe dealing in OTC derivatives and particularly CDS contracts are activities that are safe and sound for global banking institutions?

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