Net, Gross, Or GROSS

The magician has everyone talking about CDS.  Having a Credit Event is a big deal, but I think the process will be manageable – just like Lehman CDS. I think the Net notional is all that really matters. What matters most is the GROSS notional of bonds.  That is the big number as it is about 200 billion, and it is unclear where it was marked. Big banks seemed to do a good job taking write downs. Weak banks, the “zombie” banks are far more likely to have clung to positions marked at par (cash and CDS) in the hopes this was all a bad dream. If 75% was marked accurately, then there is still a minimum of 25 billion of losses that need to be taken. (200 billion * 25% unmarked * 50% loss using aggressive banking book treatment).

I do not have an estimate of where the 200 billion is marked on average, but just like Lehman, it is bond holders not CDs writers that may spark contagion. I am comfortable CDS is pretty well margined across the board, I am far less certain about bond marks – though the government owned banks are likely the worst offenders.

The other thing to watch is the impact on other countries. In spite of pledges to the contrary, CDS was triggered – it is better designed than most people give it credit for.   The basis is already weird in sovereign land where CDS has not benefitted as much from LTRO as bonds have. Watch CDS and watch bonds – LTRO has daily margin calls – the death spiral, while still unlikely, was actually created by the ECB. For 2 years, the efforts to “stop contagion” have done nothing but increase contagion risk. France didn’t get downgraded because of things going on in France, but because of their commitments to the “firewalls” and Dexia.

We rallied after Lehman filed. Be careful until it becomes more clear where the bodies are buried.