Lehman Bros. CDS Fire Sale Provides Insight

http://en.wikipedia.org/wiki/Credit_default_swap

A Credit Default Swap (CDS) is a kind of insurance
whose value goes up when a bond goes down. Essentially
it is a way of insuring bonds so that if they go bad, the
bond owner doesn't lose everything.

On 10.10.08, Lehman Brothers had a fire-sale on its
Credit Default Swaps as a way of raising capital (they're
bankrupt). It's CDS policies were valued at $0.08 - $0.09
payout per $1.00 nominal value. Basically, the value of
Lehman's CDS policies are worth less than 10% of their
face value.

This means that the insurers are on the hook for about
90% of all defaulted bonds written on bad loans associated
with Lehman Bros. If this pattern holds true throughout the
CDS industry, bad things will happen....

If we make the further assumptions that

1. 1/10 of recently-written home loans will go bad (currently
1 out of 6 indebted homeowners are under water, so this
seems conservative)

2. The bad loans represent 1/10 of the total homeowner
indebtedness (total = approx. $10 trillion, so 1/10 = $1 trillion)

3. The nominal values of the bonds written on the bad
loans is equal to the value of the loans (also conservative
since mark-to-model valuation schemes can value bonds at
more than the underlying loans)

we arrive at an insurance nightmare:

$1 trillion US total defaulted bonds -> $900 billion insurance
payout

This of course, is a CONSERVATIVE estimate. Lehman Bros.
ALONE had about $400 billion in insurance underwritten by
outside parties, so it would not be surprising to see a total insur-
ance payout exceeding $4 trillion across the entire industry.

This dwarfs the total amount of written-off debts that the banks
have acknowledged so far. Chris Cox (head of SEC) testified a
couple of weeks ago when the Bailout bill was being debated
that Congress needed to take up the issue of Credit Default Swaps.
Now we know why he was so concerned.

The major monoline bond insurers in the United States are FSA,
AMBAC, CIFG, FGIC, AGC, XL Capital, ACA Financial
Guaranty Corp., and MBIA Insurance Corporation.

If your 401K has stock in any of these corporations, get out.
You might also consider shorting these stocks. But whatever
you do, don't buy. Sell.