Testing Under Stress

Later this week, the Treasury Department is going to start picking winners and losers.  It will do so by applying a "stress test" to the balance sheets of banks using their February 9 stock price and presumably the call reports for the same day.

("Stress Test" is Econo-mese for "Totally harshing my buzz, man.")

This is where you can get quarterly call reports for banks.  Pick any bank you want.  You're looking for Schedule RC-B, Sections 4 & 5.  There is where the headline trouble lurks, in the mortgage- and asset-backed securities section.

The last column - the (haha!) "fair value" column - is a total fiction.  No one is buying or selling these things - there is no "fair value" for them.

Then, sit down, take a deep breath, and look at Schedule RC-L.  Yeah, do this with Local Downtown Bank and you're likely to see goose eggs.  That's good.  But if you look at the big boys...

JP Morgan Chase = $8.5 Trillion

Citibank = $2.7 Trillion

Bank of America = $2 Trillion (pre-Merrill Lynch merger)

These are the Credit Default Swaps reported by the banks.  It includes what they owe (CDS paper they have written) and what they are owed (CDS paper they purchased).  So they are exposed to the notional tune of over $12 Trillion.  Just for comparison purposes, these three banks, as of December 31, 2008, held off-books transactions with a face value of the 2004 US Gross Domestic Product.

("Gross Domestic Production" is Econo-mese for "if we had to put a number on what we did this year, this is it.")

So what happens if - and I'm just spitballing here - one of the largest writers of CDS paper on the planet were teetering on the edge of bankruptcy?

Mmkay... so the 3 banks above roughly "owe" and "are owed" roughly equivalent amounts.  Seriously, there's like... just a few BILLION dollars difference - a rounding error, really.  What say we suddenly declare HALF of the CDS paper that you "are owed" worthless (i.e. get in the "unsecured creditor" line in bankruptcy court).  Suddenly that rounding error turns into real money: $500 Billion to $2 Trillion.  Wow, that's some stress.

So here's how it's gonna be.  Timmy G. & Co. are gonna look at your balance sheet, see?  And they're gonna WIPE OUT your CDS positions.  And then, if you're still semi-healthy, they're gonna give you enough money so that you stay healthy.  If you're not healthy, well then it's curtains, I tell ya, curtains.  Once everyone's been stressed tested and sorted, some midnight legislation is gonna sail through Congress and through the Oval Office and it will say something like this:

"Unless proof of 1) contemporaneous exposure to debt or equity of the subject company; or 2) generation or acquisition via a clearinghouse supervised by relevant financial authorities, is submitted in the initial complaint, contracts commonly known as "credit default swaps" shall be deemed unlicensed insurance contracts and shall be unenforceable in the Courts of the United States."

And then... on to the toxic sludge on Schedule RC-B.  But this little project should keep folks busy for a good 60 days or so.