Final Lehman CDS Settlement on October 21

It is becoming clear to me what is going on with $700 billion TARP/Paulson Plan. It has nothing do with mortgages, “distressed assets”, home owners, small businesses, LIBOR, Treasury Yields, “Main Street” or any other canard the media tries to throw up.

What it is about is that governments are terrified that banks are overleveraged in derivatives. They see the settlement of the Lehman Brothers Credit Default Swaps (CDS) on October 21 as a potential back-breaker for the banking system. You can review the Lehman CDS pricing here –

http://nbcharts.blogspot.com/2008/10/lehman-cds-settlement-on-friday.html

The estimates are that the settlement of all Lehman CDS could cost $300 billion for the banks who wrote the insurance.

Here is a list of the 25 largest players in the Derivative Market. Lehman was #25! If the #25 going under costs $300 billion then what would happen if JPMorgan, with 3,250 times the exposure of Lehman were to go under?

http://www.occ.treas.gov/ftp/release/2008-115a.pdf

Look at how the money being given to banks will be disbursed –

$25 billion each to – JPMorgan (ranked #1), Bank of America (#2), Citibank (#3), Wells Fargo/Wachovia (#4)
$2.5 billion each to – Bank of New York (#6) and State Street (#7)

$10 billion each to – Goldman Sachs (Hank Paulson’s company) and Morgan Stanley

#5 HSBC is getting handed a big pile of money by the UK government

The entire process of bank consolidation the last 18 months has been designed to manage the impact of derivative losses on the banking system.

JPMorgan (#1) bought Bear Sterns (former #5 on the list), because they would have taken a $30 billion hit if Bear went under

Bank of America (#2) has now bought Merrill Lynch (# 18) and Lasalle (#22)
Wells Fargo (#6) bought Wachovia (#4) and the other bidder for Wachovia was Citibank (#3)

Bank of New York (#7) bought Mellon (#12)

RBS (#19) has been nationalize by the UK
Deutsche Bank (#24) has been bailed out by Germany
UBS (#23) will get some cash from Switzerland
Union Bank (#21) was bought by Mitsubishi – gee, that name sounds familiar…

This leaves but a few stragglers –
Suntrust (#9), PNC Financial (#10), Northern Trust (#11), Keycorp (#13), National City (#14), US Bank (#15), Regions Bank (#16), BB&T (#17) and Fifth Third (#20)

I am not sure whether or not they will survive, but my guess is that these banks will not be bought out at premiums.

Then there is that little company called AIG which wrote the most CDS insurance. The initial bailout for AIG was $87 billion. Then last week, the Fed announced another infusion of $25 billion. My guess is that the government is funding AIG to make sure that they are able to make good on the CDS insurance they wrote. If AIG did not pay, then I am all but certain that several banks and hedge funds would become insolvent and that would lead to more problems in the financial system.

No doubt Morgan and Goldman are being given the money to cover any losses sustained by the hedge funds with which they trade. I am not sure if the Fed gave the money to the other banks to help them cover CDS insurance they wrote, or to cover them if some of the banks which sold them CDS insurance will not be able to pay.

So October 21 is the key date. If things don’t blow up, then we may be okay for a while. I am going to operate under the assumption that the best buying opportunity will a retest of last week’s lows between now and October 21.