Counterparty Risk Moves to the Fore

The best news to come out of the Fed meeting was that Tim Geithner wasn’t there. That means he was in New York, where he belongs, worrying about AIG and counterparty risk rather than macroeconomics and the Fed Funds rate. Good decision, especially since the FOMC vote was unanimous and Geithner would surely have voted the same way, making no difference at all.

For all your AIG rumors, Dealbreaker is the place to go: a government bailout! A government backstop of a private bailout! Conservatorship! And then, of course, there’s the prospect that the whole shop will somehow be bought by Hank Greenberg. Failing that, we know where this is going:

If a financing solution is not reached, A.I.G. may file for bankruptcy as soon as Wednesday, a person briefed on the matter said Monday night. The company has hired the law firm Weil, Gotshal & Manges — which is also handling the Lehman Brothers bankruptcy — to draw up bankruptcy papers.

Given the Barclehs deal, bankruptcy might not be the end of the world. Some private-sector derivatives powerhouse might be able to step in and take over AIG’s derivatives book, without any of AIG’s bonded liabilities. Yes, AIG has written a lot of credit protection, and that doesn’t look like a very smart decision right now. But anything is attractive at the right price.

Right now more than ever, nobody knows anything — but I’m 99% sure that Tim Geithner is fully concentrated on the issue of counterparty risk right now, and is working to mitigate it by any means necessary. News like this certainly concentrates the mind:

Counterparty risk in the market for credit default swaps, as measured by the CDR Counterparty Risk Index (CRI), hit an all-time high on Tuesday as traders reacted to Lehman Brothers’ bankruptcy and the unknown future of AIG.

“The market is in turmoil as massive unwinds of open CDS positions sweep across all desks and uncertainty surrounding the viability of the broker-dealer business model spreads contagiously across Europe and the US,” Tim Backshall, CDR’s chief strategist, said.

The CRI hit 389.33bp this morning, compared with its previous record wide of 250bps during the Bear Stearns-induced market panic.

I have to admit I’ve never heard of the Counterparty Risk Index before, it sounds like a very useful metric although I have no idea how it’s calculated or how long it’s been in existence.

One thing which does occur to me: could this be the end of the boom in credit default swaps? If counterparty risk really is somewhere north of 300bp, then that dwarfs the amount of credit risk that is ostensibly being insured. It surely won’t be long until investors decide that there are much more sensible ways of trying to hedge their credit-risk exposure.

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